1

NATIONAL UNIVERSITY OF SCIENCE

AND TECHNOLOGY
GRADUATE SCHOOL OF BUSINESS



EXECUTIVE MASTER OF BUSINESS
ADMINSTRATION PROGRAMME




INTERNATIONAL FINANCE AND
TRADE EMBA (5207)

2

Chapter One: ...................................................................................... page 1.
International Business Finance and Financial markets
Chapter Two......................................................................................page 8.
International Flow of Funds
Chapter Three.......... .........................................................................page 17.
Relationship between Inflation, Interest Rates and Exchange Rates
Chapter Four.....................................................................................page 23.
Government Intervention in the Exchange Foreign Market
Chapter Five.......................................................................................page 29.
Foreign Exchange Exposure Measurement and Management
Chapter Six.........................................................................................page 40.
Country Risk Analysis
Chapter Seven....................................................................................page 46.
International Treasury Management and Financing
Chapter Eight ....................................................................................page 51.
Multinational Cost of Capital and Capital structure
Chapter Nine .....................................................................................page 58.
Foreign Direct Investment
Chapter Ten ......................................................................................page 62.
Multinational Capital Budgeting Decisions
Chapter Eleven..................................................................................page 69.
International Payments




3

SYLLABUS

Course Objectives:

To identify the main goal of the multinational corporation (MNC) and conflicts with that goal;
To describe the key theories that justify international business;
To explain the common methods used to conduct international business.
To describe the background and corporate use of the following international financial markets:
To identify the commonly used techniques for hedging international exposure;
To analyze country risk indicators
Course Synopsis:

The major topics and concepts covered in this course module include, Introduction to International
Financial Management ,International Capital Flows ,International Financial Markets, Exchange Rate
Determination and Currency Derivation, Government Influence on Exchange Rate movements,
International Parity and International Parity Theorems ,Forecasting Exchange rates ,Managing
Exposure in International Trade, Foreign Direct Investment and Country Risk Analysis

Delivery Methods:

The course will be delivered through lectures, group discussions and case presentations. Notes and hand outs
will :be provided when ever its necessary.
Course Assessment
The course is assessed through the following three components:
Final Examination 60%
Individual Assignment 20%
Group work (Case Study) 20%
Total 100%


4

Module delivery programme

LESSONS START AT 0830 AND END AT 1600HRS EVERYDAY FROM THE ..........................2011 TO
............................. 2011.)

DAY TOPIC S Requirements
DAY ONE Topic 1-
Introduction to International Financial
Management , International Capital Flows
Topic 2-
Exchange Rate Determination
Forecasting Exchange


Notebook, calculator
Read Chapter 1,2 Jeff
Madura (J S. E S)
Eiteman Stonhill (E, S)

DAY TWO Topic 3
Parity Theorems
International Parity Theorems

Read Chapter
Read Chapter 4,
J S , ES, Module

DAY THREE Topic 4
Government Influence on Exchange Rate

Topic 5
Exposure Measurement and Management
Read module

JM, ES
DAY FOUR Topic 6
Country Risk Analysis
Topic 7
Treasury Management and Financing

Read Module , J S ES,
case
DAY FIVE Topic 8
Cost of International capital
Topic 9
Foreign Direct Investment


Read module

J S , E S, Case
DAY SIX Topic 10
Multinational Capital Budgeting
Topic 11
International Payments
Read
Module, JS, ES, Case
study
DAY SEVEN Case Presentations and Revision

Group Presentations
on case studies




5

AIMS of the Module

The module aims to examine the theory and practice of modern international finance and trade.
The rapid growth of MNCs has highlighted the significance of the international finance function in
firms while the greater volatility of exchange rate systems and deregulation of financial markets
accentuate the need for financial managers to cope with complex cash and currency management,
investment and financing decisions.
On completion of the module students should:
1. Critically discuss the strategic role of international finance and the drivers of globalisation of
business.
2. Discuss the theoretical and practical issues of exchange rate determination.
3. Discuss currency and interest rate risks and critically evaluate their management techniques
including derivatives.
4. Critically discuss the various sources of finance for multinational companies and the
complexities of financial markets in which the international finance manager operates.
5. Critically evaluate international capital investment decisions within the context of corporate
objectives and strategies using appropriate financial techniques.
6. Critically discuss the opportunities and constraints in international treasury management
and mobilisation of finance around the globe














6

Chapter One:

1.0.International Business Finance and Financial markets
Learning Outcomes:
To recognize the main goal of the Multinational Corporation (MNC) and the factors that
conflict with that goal.
To review and examine the key theories that explain the existence of International Business.
To understand common ways in which International Business is conducted.
To discuss the Fundamentals of International Finance and Financial Markets.
KEY TERMS
MULTINATIONAL CORPORATION (MNC) ARBITRAGE
CAPITAL MARKET FOREIGN EXCHANGED RATE
SPOT RATE FORWARD RATE
FLOATING EXCHANGE RATE MANAGED EXCHANGED RATE

1.1. Objectives of Multinational Corporation Financial Management
Financial management in a domestic environment is one of the curious combinations of
mathematics precision with the source of all random behaviour. When financial management is
stretched across geographic, cultural, and political and jurisdiction boundaries, more variables are
introduced and considered as compared to domestic financial management.
The traditional areas of financial management are:
Capital Structure: Determination of what proportions of debt and equity re necessary for
the firms maximum financial health and long-term competitiveness.
Capital Budgeting: Analysis of investment opportunities and lines of business activity that
are considered by the firm.
Long term financing: Selection, issuance and management of long term sources of capital
by the firm
Working capital management: Management of the levels and composition of the firms
current assets and their sources of funding.
International Financial Environment will consider issues such as global financial management,
Balance of payments, repositioning of funds, multinational taxation and capital budgeting.




Figure 1.1. International Financial Environment
Why are firms motivated to expand their business internationally?
The commonly accepted goal of an
the Anglo-American approach to business.
theory and thinking has resulted in the development of other internationally accepted goals of
business. The most recent and popular approach
1.2. Theories of International Business
1. Specialization by countries can increase production effi
2. Imperfect Markets Theory
The markets for the various resources used in production are imperfect.
3. Product Cycle Theory
As a firm matures, it may recognize additional opportunities outside its home
country.




7
.1. International Financial Environment
motivated to expand their business internationally?
The commonly accepted goal of any MNC is to maximize shareholder wealth. This is referred to as
American approach to business. However the development of Financial Management
ng has resulted in the development of other internationally accepted goals of
popular approach is the corporate wealth maximization.
Theories of International Business
Specialization by countries can increase production efficiency.
The markets for the various resources used in production are imperfect.
As a firm matures, it may recognize additional opportunities outside its home

This is referred to as
However the development of Financial Management
ng has resulted in the development of other internationally accepted goals of
is the corporate wealth maximization.
As a firm matures, it may recognize additional opportunities outside its home
8


Figure 1. 2 International Product Life Cycle
O Firm exports
product to
accommodate
foreign demand.
O Firm creates
product to
accommodate
local demand.
The International Product Life Cycle
OFirm
establishes
foreign
subsidiary
to establish
presence in
foreign
country
and
possibly to
reduce
costs.
Oa. Firm
differentiates
product from
competitors
and/or expands
product line in
foreign country.
Ob. Firms
foreign
business
declines as its
competitive
advantages are
eliminated.
or

The theory of internalisation causes firms to expand into regional and international markets
into order to preserve their technology and other forms of competitive advantages
1.3. Multinational Corporation Decision to go into International Markets
The decision to go into international markets should be premised on the shareholder value addition.
A company should go international if the value of shareholders is increased by the cash flow arising
from the cross border investment.
Figure 1.3 shows the cost and benefit analysis for domestic firms versus MNCs. As the firms asset
base increases as a result of investing in international markets, the marginal return for a MNC will
increase at a higher rate than that of a purely domestic firm.
1.4. The Potential For Conflict for a MNC
From an economic perspective, host countries welcome multinational firms because they are viewed
as agents of technology transfer and host-country economic development. From a business
perspective, multinational firms are eager for opportunities to invest in geographic locations where
they can earn a rate of return high enough to compensate them for the perceived level of risk.
National and international market imperfections provide these opportunities.
Although a strong economic and business rationale exists for the success of multinational firms, they
must live within host-country economic, political, social, and religious goals and the potential for
conflict with such goals is imminent. Thus, maximizing the value of the multinational firms for the
benefit of their shareholders may conflict with concepts of national sovereignty, which nearly always
override the rights of individual firms, multinational or domestic. Therefore, in choosing operational
financial goals and marking policy decisions to implement these goals, financial executives of
multinational firms must recognize the institutional, cultural, and political differences among host
9

countries, which in turn lead to different national persecutions of the proper goals of a business
entity.


Marginal
Return on
Projects
Purely
Domestic
Firm
MNC
Asset Level
of Firm
Investment
Opportunities
Fig 1.3. International Opportunities
Cost-benefit Evaluation for
Purely Domestic Firms versus MNCs
Appropriate
Size for Purely
Domestic Firm
Appropriate
Size for MNC
X Y
Marginal
Cost of
Capital
Purely
Domestic
Firm
MNC
Financing
Opportunities


1.5. Multinational Firms and Fluctuating Exchange Rates

An understanding of foreign exchange risk is essential for managers and investors in todays
environment of volatile foreign exchange rates. The present international monetary system is
characterized by a mix of floating and managed exchange rate policies pursued by each nation in its
own best interest. When a currency increases in relative value, as was the case for the U.S. dollar
between 1981 AND 1985, U.S. exports decline because their prices become too high when converted
to the currency of the foreign importer. Likewise, imports increase because they cost less in local
currency terms. In the U.S. example, the loss of exports hurt gross domestic product and
employment, but low-cost imports benefited consumers and helped keep a lid on inflation. Thus,
any firm that exports or imports, or even a domestic firm that competes against imports, would be
directly affected by changes in the value of the U.S. Dollar. All firms must understand foreign
exchange risk in order to anticipate increased competition from imports or to realize increased
opportunities for exports.
Multinational have the advantage of being geographically diversified. They need to understand
foreign exchange risk in order to shift production to countries with relatively undervalued currencies
and to promote sales in countries with overvalued currencies. They also typically have access to
international sources of funds. The relative cost of these funds, after consideration of exchange rate
10

effects, is likely to change, thereby firms giving multinational firms an opportunity to lower their cost
of capital.
1. 6. Multinational Firms and Capital Markets
During the past decade an explosive growth has occurred in the use of international capital markets
to lower a firms cost of capital. This growth has been fuelled in part by a trend toward liberalizing
securities markets in the most important world capital markets, which has motivated a large net
increase in international portfolio investment. The United States was the first to liberalize.
Subsequently, the European Union countries have adopted rules that should eventually lead to an
integrated money and capital market. The Big Bang of October 1986 was the U.K. version of capital
market liberalization. Other EU members followed soon after with their own deregulation initiatives.
Even the Japanese capital market has been slowly liberalized. Foreign firms have been admitted to
the Tokyo Stock Exchange. Restrictions on the use of the yen as an international currency have been
eased and foreign firms may raise capital in Japan.
Although global integration is well started, many restrictions on the free flow of capital still exist,
especially in the newly-emerging capital markets. Furthermore, performances of stock and bond
markets vary widely among countries and over time. Therefore opportunities still exist for both firms
and portfolio investors to benefit from diversifying internationally.
1. 7. Multinational Firms and Corporate Governance
Capital market integration has enabled multinational firms to source their equity and debt in global
markets. However, in order to attract global investors, it has become necessary for multinational
firms to become more shareholder friendly. The traditional corporate governance norms, which
have fostered both the corporate wealth and shareholder wealth maximization models, depending
on country, are under attack.
In the Anglo-American markets, some politicians, academics, and interest groups have been
espousing changing corporate governance stakeholder capitalism. This would be consistent with
moving part-way toward the goal of corporate wealth maximization
In the non-Anglo-American markets, the same political pressures exist to change corporate
governance norms to permit more shareholders influence. This means weakening takeover
defences and adopting more of the policies promoted by agency theory in the Anglo-American
markets.
Where will it end? Those firms that need to raise capital globally will need to move part of the way
toward the shareholder wealth maximization model. On the other hand, it does not appear that they
are likely to remove such takeover defences as dual class of stocks. Even the New York Stock
exchange, considered one of the last great bastions of pure shareholder wealth, now accepts listings
from firms with dual classes of stock (If that is the tradition in the firms home country). Even if
takeover defences remain in place, however, it is likely that multinational firms might adopt such
agency theory incentives as more significant stock option programmes for managers in order to
align their interests with those of the shareholders.
11

In the Anglo-American markets, multinational firms are likely to move part of the way toward
stakeholder capitalism as a larger share of their markets, production, assets, debt, and investors
are located outside their home countries. Wherever the stakeholder model is the norm, pressure
will increase on multinational firms to consider other interest groups, rather than mainly their home
country shareholder group.
1. 8 The Foreign Exchange Market
Foreign exchange markets exist because most countries have their own monetary units in which
business is done within their own borders. Trade between countries in goods and securities
therefore requires the exchange of national moneys. The foreign exchange market is where this
occurs. We dene the exchange rate as the domestic currency price of a unit in foreign currency.
Since each country or currency area has an exchange rate with every other currency area, there are
many more exchange rates than there are currencies. Internal consistency of this network of
exchange rates is maintained by arbitrage. The latter is dened as a set of simultaneous transactions
at existing exchange rates from which a sure prot can be made as a result of discrepancies between
those rates. For example, if the exchange rates between the dollar, yen and pound were such that
one could make a prot by converting dollars to yen, yen to pounds, and pounds back into dollars,
foreign exchange traders will make these trades and quickly create market pressures that will
restore consistency between the rates. It is customary for traders to use certain currencies, like the
U.S. dollar, the British Pound, the Euro and the Japanese yen as vehicle currencies or international
moneys. This means that trade between countries other than vehicle-currency countries is
conducted in a vehicle currency with the local moneys being exchanged for the vehicle currency
rather than for each other.

1. 9. Reasons for investing in Foreign Markets:
to take advantage of favourable economic conditions;
when they expect foreign currencies to appreciate against their own; and
to reap the benefits of international diversification.
1. 10. Borrowers borrow in foreign markets:
to capitalize on lower foreign interest rates and due to international market
fragmentation
when they expect foreign currencies to depreciate against their own.
1.11. Forms of International trade
1.11.1. International Trade - importing and exporting - conservative (often first step) Low barriers to
entry, minimal risk.
1.11.2. Licensing - allows expansion of a firm's technological advantages without major costs of
foreign investment or transportation. Problem of ensuring (enforcing) quality control in foreign
production process.
1.11.3. Franchising - Like licensing, it allows firms to penetrate foreign markets without major
foreign investment (enforcement of quality control can be a complex issue, particularly for consumer
12

firms like McDonalds and KFC, where brand uniformity must be weighed against cultural diversity of
tastes).
1.11. 4. Joint Ventures - allows two firms to apply their comparative advantages to a specific joint
actvity in a relatively simple manner. Avoids the entanglements and complications of mergers and
acquisitions.
1.11.5. Acquisition of Existing Operations (Subsidiary) - Opportunity to achieve quick market
penetration (existing customer base). Requires high foreign (capital) investment and is thus riskier.
(FORM OF DIRECT FOREIGN INVESTMENT - DFI)
1.11.6. Establishing New Foreign Subsidiary - Also requires large capital investment (perhaps not as
large as an acquisition) but also risky.
1. 12. Barriers to International Market Integration.

The markets for real or financial assets are prevented from complete integration by barriers such as
tax differentials, tariffs, quotas, labour immobility, communication costs, cultural differences, and
financial reporting differences. The formation of regional blocks such as the Southern African
Development Community (SADC), the Common Market for Eastern and Southern Africa (COMESA),
Economic Community of West African States (ECOWAS), European Union (EU) and Southern African
Customs Union (SACU) fragments the operations of a global market.
The common aims for all these economic groupings are to remove barriers to entry and create
bigger markets for their goods and services. Yet, these barriers can also create unique opportunities
for specific geographic markets that will attract foreign investors.

Chapter One Practice Questions

1. Describe constraints that interfere with the MNCs finance managers objective of attempting to
maximize shareholders value.

2. It is always suggested that floating exchange will adjust to reduce or eliminate any current account
deficit. Explain why this adjustment would occur.
3. What are the main objectives of IMF and to what extent are these objectives being achieved?

4. What is the role of a factor in international trade transactions? How can a factor be useful to an
exporter?

5. Explain how the development of foreign trade would be affected if banks did not provide trade-
related services.

6. What is counter trade? Illustrate your answer.
13

Chapter Two


Topic: International Flow of Funds
Learning Outcomes:
To explain the key components of the balance of payments.
To explain how the international flow of funds is influenced by economic factors and other
factors.

KEY TERMS

BALANCE OF PAYMENT(BOP) TRADE FLOWS
TRADE DEFICIT PRIVATE CAPITAL FLOWS
CAPITAL ACCOUNT BOP DEFICIT
BOP DEFICIT BOP SURPLUS
GOVERNMENT RELATED TRANSFERS NET ERRORS AND OMISSIONS
BELOW THE LINE ITEMS ABOVE THE LINE ITEMS
J CURVE EFFECT

Comments
2. 0. Balance of payments statement:
This is a measurement of all transactions between all the residents of a country vis-a-vis. the
rest of the world over a period of specified time, in most cases one year. Every time
something is sent abroad, something (which may be a cash balance in a bank) is received in
return from abroad. At any time, therefore, the value of what is received must be equal to
the value of what has been given. Because debits must equal credits individually, the inflows
must equal the outflows in the aggregate balance of payments.
2. 1.1 Factors Affecting International Trade Flows
Inflation: A relative increase in a countrys inflation rate will decrease its current account, as
imports increase and exports decrease.
National Income: A relative increase in a countrys income level will decrease its current
account, as imports increase.
Government Restrictions: A government may reduce its countrys imports by imposing
tariffs on imported goods, or by enforcing a quota. Note that other countries may retaliate
14


Fig. 2.1.Foreign Cash Flow Chart of an
MNC
MNC Parent
Foreign
Subsidiaries
Foreign
Business
Clients
Eurocurrency
Market
Eurocredit &
Eurobond
Markets
International
Stock Markets
Foreign
Exchange
Markets
Export/Import
Export/Import
Short-Term
Investment
& Financing
Long-Term
Financing
Foreign
Exchange
Transactions
Medium- &
Long-Term
Financing
Dividend
Remittance
& Financing
Long-Term Financing
Medium- & Long-Term Financing
Short-Term
Investment & Financing

by imposing their own trade restrictions. Sometimes, though, trade restrictions may be
imposed on certain products for health and safety reasons.
Exchange Rates: If a countrys currency begins to rise in value, its current account balance
will decrease as imports increase and exports decrease. Note that the factors are interactive,
such that their simultaneous influence on the balance of trade is a complex one.
2.2. Analytical Arrangement of the BoP:
In any balance of payments presentation, all transactions between residents and non-
residents are conceptually or ideally divided into two analytical categories: current account
and capital account items.

Credits: All transactions leading to inflow of funds or earned foreign exchange are recorded
as credits.
Debits: Are transactions leading to outflow of funds or expended foreign exchange.
The recording of all transactions in the balance of payment statement is done by double
entry bookkeeping: meaning each transaction has both a credit and debit entry. Thus, at any
15

given time, the ,total of credits and debits will be identical but opposite in sign for a countrys
balance of payment statement in aggregate.
2. 3. The Balance of Payment Deficit:
For a trade deficit to occur (the value of imports exceeding exports) some importers must
have not paid in real goods their imports or there werent enough aggregate exports to pay
for all the imports. This means some of the imports were made on credit or through a
depletion of some of the cash or other assets held by exporters abroad or the government
came to their aid by paying for these excess imports.


In either case, we can describe the situation as selling financial assets to foreigners (i.e.,
borrowing from abroad). Selling financial or real assets to foreigner initiates capital inflows;
buying assets from foreigners results in capital outflows.


Therefore unless the government chooses to intervene, private capital inflows must always
be sufficient to cover the trade deficit (Private capital inflows occur when foreigners lend to
us, or invest here, or we draw down on our assets held abroad). More generally, the net
foreign capital inflow must be sufficient to offset the export shortfall in the trade account.

The above argument points out that private exports plus capital inflows must equal private
imports plus capital outflows, unless the government chooses to help the private sector pay
for some of those imports of goods (or financial assets) by drawing down on its international
reserves. When it does so, private purchases of goods and assets from abroad (imports plus
capital flows) exceed private sales of goods and assets to the rest of the world (exports plus
capital inflows), and we say there is a balance of payments deficit

Without the governments intervention, credit transactions must equal debit transactions
implying there cannot be a balance of payments deficit or surplus. Thus, if there is an overall
surplus or deficit, it can only be to the extent of intervention by the central bank. Therefore,
to the extent that the central banks reserves decreased, there was an overall deficit and to
the extent the central banks reserves increased, there was a surplus.
2. 3. Current Account: (summary of exports and imports)
The current account balance is composed of

a. The trade account
- Export of goods
- Import of goods
b. Payment for Services:
- The net amount of payments of interest to foreign investors and receipts from
foreign investments
- Payments from international tourism; and
16

c. Unilateral transfers:
- Private gifts and grant
2.4. Capital Account:

The capital account is composed of all capital investments made between countries and is further
divided into two:

(i) Direct foreign investment, and
(ii) Purchases of securities with maturities exceeding one year.

Other significant sections of BoP statement are the official reserves and government related
transfers together with the net errors and omissions.

2. 5. Official Reserve Position:
This section is sometimes referred to as below the line and represents the movements in the
Reserve Position of the Apex Monetary Authority of the country and is always of opposite in
sign to the total balance of all the items above the line.
2. 6. Net errors and Omissions:
Quite often the official reserve movement never equals the above the line items and thus a
balancing figure is required which represents a category of unrecorded transactions. This is
the Net Errors and omissions entry.













17


Transylvanias Balance of Payments
Billions

Debits Credits Nature of
Balance

Exports (goods sold to foreigners) 11

Imports (goods bought from
foreigners) -16
Net Balance - 5 Trade
Balance

Services like tourism and
Investments income
(and interest paid or received) -2 3

Aid and Gifts (a plug category) 1

Net Balance -3 Current
Account
Balance

Financial and real assets sold
to foreigners (Capital inflows) 3

Financial and real assets bought
from foreigners (Capital outflows) -2
18


Net Balance -2 Overall
Balance

Governments financial assets sold
(Foreign exchange reserves reduced) 3
Governments financial assets bought
(Foreign-exchange reserves increased)

Errors and omissions (plug category) -1

-21 21

2. 7. Managerial Significance of BoP Imbalances
The significance of a deficit / surplus in the balance of payments has changed since the
advent of floating exchange rates. Traditionally, under fixed exchange rate regimes, BoP
measures were used as evidence of potential pressure on a countrys foreign exchange rate
(the price of foreign currency in terms of the local currency). The presence of a surplus
indicated potential foreign exchange rates appreciation and a deficit signified potential
depreciation.
2. 8. Exchange Rate Impact:
The relationship between the BoP and exchange rate can be illustrated by the use of the
following equation:
Current Account Balanc e + [(Capital Account Balance +Financial Account Balance)] + Reserve
Balance

(X-M) + [(CI-CO) + (FI-FO)] + FXB

= Balance of Payments Equilibrium - BOP

Where:
X is exports of goods and services.
M is imports of goods and services.
CI is capital inflow (foreign direct investments)
19

CO is capital outflow.
FI is financial inflow.
FO is financial outflow.
2. 9. Correcting A Balance of Trade Deficit
By reconsidering the factors that affect the balance of trade, some common correction methods can
be developed. For example, a floating exchange rate system may correct a trade imbalance
automatically since the trade imbalance will affect the demand and supply of the currencies
involved.
However, a weak home currency may not necessarily improve a trade deficit. Foreign companies
may lower their prices to maintain their competitiveness. Some other currencies may weaken too.
Many trade transactions are prearranged and cannot be adjusted immediately. This is known as the
J-curve effect. The impact of exchange rate movements on intra company trade is limited.
Capital flows usually represent portfolio investment or direct foreign investment. The DFI positions
inside and outside the U.S. have risen substantially over time, indicating increasing globalization. In
particular, both DFI positions increased during periods of strong economic growth. Foreign exchange
balance is foreign exchange reserves balance of the country.
2. 10 Effects of BOP imbalance on a country
The effect of an imbalance in the balance of payments of a country works differently depending on
whether that country is pursuing a fixed, floating, or a managed exchange rate system.

2. 10.1 Fixed Exchange Rate Countries:
In this foreign exchange regime business managers use the balance of payments statistics to
forecast potential devaluation or revaluation of the official exchange rate. A deficit means a
country is a net supplier of its currency to the forex market and therefore should sell some
of its forex reserves to mop up its currency back to maintain a fixed exchange rate. The
reverse is also true in case of a surplus in the balance of payments.

2.10.2. Floating Exchange Rate Countries:
A country running a deficit means it has excess supply of its domestic currency appearing on
foreign exchange markets, and like all goods in excess supply, the market will rid itself of the
imbalance by lowering the price-- thus resulting in a depreciation of the domestic currency
in the foreign exchange market. The reverse case is also true for a country running a surplus
in the balance of payments. Therefore for a country following a floating exchange regime,
BoP deficit/surplus is used to forecast potentials for depreciation/appreciation of the foreign
exchange rate.
2. 10. 3. Managed Float:

20

A country with a managed float that wishes to defend its currency may choose to raise its
domestic interest rate to attract additional capital from abroad or sell excess foreign
exchange to maintain a given level of foreign exchange rate. This action alters market forces
and creates additional market demand for the domestic currency, thus propping the
besieged currency.

2. 11. Economic Development Impact

From a national income viewpoint, a deficit on current account might have a negative effect
on GDP and employment if underemployment exists, whereas a surplus could have a
positive effect. A current accounts deficit signifies excess of imports over exports. However,
at full employment capital will be attracted from abroad to enhance capacity leading to
increased employment creation. A surplus in the current account has the reverse impact.

Therefore, generally, a deficit has a negative impact on employment and therefore income
(because it exports jobs), unless such deficits are compensated by capital inflows in the
capital account (importation of capital from abroad).

2. 12. Issues in International Capital Flows
The capital account and its subjective financial flow (autonomous) generate equal concern
for both the business firms and governments. Short-term capital flows respond primarily to
interest rate differentials and interest rate expectation changes across countries. No doubt
some countries with deficits in their BoP have always financed such deficits with short-term
capital flows as they fine-tune their domestic interest rates.

2. 13. Short-term capital flows are primarily motivated by the interest rate
differentials between the countries.

Long term capital funds: long term capital flows play a significant role in the BoP structure
of many nations. Whereas short- term capital tends to follow interest rate movements, long-
term capital flow is typically attracted to economic and business environment opportunities
expected to provide significant long-term stability and economic growth.

Long-term capital flows are typically attracted to stable economic and business
environmental conditions Opportunities for economic growth
2.14. Agencies that Promote International Capital Flows
A) International Monetary Fund (IMF)
The main objectives of IMF:
1- Promote co-operation among countries on international monetary issues.
2- Promote stability in exchange rates
3- Provide temporary funds to member countries attempting to correct imbalances of
international payments.
4- Promote free mobility of capital funds across countries, and
5- Promote free-flow of funds and trade.
21

B) World Bank (IBRD) and its Associates

Primary objectives are to make loans to countries in order to enhance economic
development and by focusing on Government lending.

C) International Financial Corporation.

This institution was established to promote private enterprise development within the
member countries. In carrying out this function, it focuses on private sector
development and stock markets round the world.

D) International Development Association
Extends loans to less developed countries on concessional interest rates and is one of
the wings of the World Bank

E) Bank for International Settlement:
It facilitates co-operation among countries with regards to international transactions
and settlements.

I. Regional Development Agencies which are extensions of the World Bank as it
owns a substantial share in all of them:
-Asian Development Bank (ADB).
-American Development Bank (ADB).
-African Development Bank (ADB).
-European development bank of recent origin

2. 15 International Capital Flows
Factors Affecting DFI :
Changes in Restrictions
o New opportunities may arise from the removal of government barriers.
Privatization
o DFI has also been stimulated by the selling of government operations.
Potential Economic Growth
o Countries with higher potential economic growth are more likely to attract DFI.
Tax Rates
o Countries that impose relatively low tax rates on corporate earnings are more likely
to attract DFI.
Exchange Rates
o Firms will typically prefer to invest their funds in a country when that countrys
currency is expected to strengthen.
Factors Affecting International Portfolio Investment
Tax Rates on Interest or Dividends
o Investors will normally prefer countries where the tax rates are relatively low.
22

Interest Rates
o Money tends to flow to countries with high interest rates.
Exchange Rates
o Foreign investors may be attracted if the local currency is expected to strengthen.

Chapter Two Practice Questions

1. What restrictions would prevent the exchange rate not always to adjust to a
Current account deficit?

2.Explain the implications of a Balance of Payment deficit for a country that operates in a fixed exchange
rate market, managed floating exchange rate market and free floating exchange.

3.Discuss the origins and functions of SADC, ECOWAS and COMESA.










Chapter Three
Relationship Between Inflation, Interest Rates and
Exchange Rates and the International Fisher Effect

Learning Outcomes
To examine foreign exchange rate forecasting techniques.
To observe the types of exchange rates systems used by different governments
23

Understand how governments to intervene directly to affect exchange rates
Understand the theory of Purchasing Power Parity (PPP) and its relationship to exchange rate
changes.
Understand the theory of the International Fisher Effect (IFE) and its relationship to exchange
rate changes
To be able to compare and contrast the PPP theory, IFE theory, and Interest Rate Parity (IRP).
To understand how firms can benefit from forecasting exchange rates
To review and examine common techniques used for exchange rate forecasting.
Understand how forecasting performance can be evaluated.
KEYS TERMS

PURCHASING POWER PARITY (PPP) LAW OF ONE PRICE I
INTERNATIONAL FISHER EFFECT (IFE) INTEREST RATE PARITY (IRP)
EXCHANGE RATE FORECASTING LOCATIONAL ARBITRAGE
TRIANGULAR ARBITRAGE COVERED INTEREST ARBITRAGE
COVERED INTEREST ARBITRAGE EFFICIENT MARKET CONDITIONS
EXCHANGE RATE FORECASTING FUNDAMENTAL FORECASTING
TECHNICAL FORECASTING MARKET BASED FORECASTING
MIXED FORECASTING.












Figure 3.1. Exchange Rate Behavior
Existing spot
exchange rates
at other locations
Existing cross
exchange rates
of currencies
Existing inflation
rate differential
Future exchange
rate movements
Existing spot
exchange rate
Existing forward
exchange rate
Existing interest
rate differential
locational
arbitrage
triangular
arbitrage
purchasing power parity
international
Fisher effect
covered interest arbitrage
covered interest arbitrage
Fisher
effect
24


3.1 Purchasing Power Parity (PPP)
When one countrys inflation rate rises relative to that of another country, decreased exports and
increased imports depress the countrys currency. The theory of purchasing power parity (PPP)
attempts to quantify this inflation-exchange rate relationship. The absolute form of PPP, or the law
of one price, suggests that similar products in different countries should be equally priced when
measured in the same currency. The relative form of PPP accounts for market imperfections like
transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar.
Locational Arbitrage - Represents momentary differences in exchange rates between and among
regional markets. Such differences are quickly resolved by actions of investors to take advantage of
differing prices for the same currency.
Triangular Arbitrage - Involves situations where exchange rates for currency A in terms of major
currencies B and C are momentarily inconsistent with the exchange rate existing between B and C.
The result is an opportunity for investors to purchase Currency A using the major currency with the
more favourable rate (say, B) and sell A for the other currency (C).
Covered Interest Arbitrage - Involves opportunities to take advantage of opportunities created by
inconsistencies between the risk free interest rate investment opportunities available for two
different opportunities and the interest rate differential implied by forward exchange rates between
the two currencies based on the theory of interest rate parity

3.1. 1. Relationship Between Spot and Forward Exchange Rates

The forward discount on domestic currency is dened as the excess of the forward price of foreign
currency in terms of domestic currency over its current spot price, taken as a fraction or percentage
of the current spot price.

= ( I)/ (Equation 1)
where I is the spot price of foreign currency in terms of domestic currency, is the forward price,
and is the forward discount/premium. A speculator who thinks that the future spot price of
foreign currency at the time a forward contract matures will be less than the forward price, can
expect to gain by selling the foreign currency forwardor taking a short position in itand then
purchasing it spot for delivery under the contract when the forward contract comes due. This
assumes, of course, that the speculator is willing to bear the risk involved. The possibility of prot
results from a deference between the forward rate and the spot rate expected at the maturity date
in excess of any allowance for riskthe current spot rate is irrelevant. Action by all speculators will
drive the forward price of the foreign currency in terms of domestic currency into equality with their
expected future spot price, plus or minus an allowance for foreign exchange risk. The latter is
dened as the risk of loss through changes in the exchange rate when taking an uncovered position.
If the foreign exchange risk premium is zero, the forward exchange rate will equal the markets
expectation of the spot rate that will hold on the due date of the forward contract.

Let be the expected future price of foreign currency in terms of domestic currency. Adding and
subtracting it within the brackets in equation (1) and rearranging the terms, we obtain

= ( + )/= ( )/ + ( )/= T+ E ( Equation 2)

25

where T is a premium to cover foreign exchange risk and E is the expected rate of change in the
domestic currency price of foreign currency. The condition for Equation (2) to hold is that market
participants form their expectations rationally in the sense that they use all information available to
them in making buy and sell decisions. This also implies that the foreign exchange market is ecient.
Equation (2) can thus be called the ecient markets condition.

3.2. Interest Rate Parity

Ignoring risk considerations, an arbitrage opportunity will exist whenever the domestic interest rate
exceeds the foreign interest rate by more or less than the forward discount on the domestic
currency. If the interest rate deferential is greater than the forward discount it pays to shift funds
from foreign securities to domestic securities and cover oneself by purchasing foreign currency
forward to guarantee return of the funds at the exchange rate indicated by the forward discount. If
the interest rate deferential is less than the forward discount it pays to shift funds in the other
direction, covering oneself by selling foreign currency forward. The widespread attempt to take
advantage of discrepancies between the interest rate deferential and the forward discount will
eliminate them. As a result id If = (1) where id and if are the domestic and foreign interest rates
and is the forward discount on domestic currency. Since there is no reason to assume that
securities in the two countries are equally risky, this equation has to be modied by including a risk
premium.

id if = + X(Equation 3)

where X is a premium for political or country- specic risk. Note that this risk is dierent from
foreign exchange risk because it will exist even if the exchange rate is immutably xed and is
therefore zero. The condition in equation 3 is called the interest rate parity condition.

3.3. Domestic Interest Rate Determination

The two conditions, ecient markets and interest rate parity can be com-
bined by substituting the ecient markets equation = T+ E(1)into the interest parity equation
idif= + X(3) to obtain id if= T+ X+ E (3) where T and X are the foreign exchange and
country-specic risk premium and E is the expected rate of depreciation of the domestic currency
in terms of foreign currency. The two risk premium can be consolidated to express Equation (3) as
I d if= + E(Equation 4)
which can be rearranged to yield an equation determining the domestic interest rate
,id= if+ + (Equation 5)
This equation reveals a fundamental constraint on domestic macroeconomic policy. The only way
the domestic government can alter the domestic interest rate (assuming that it cannot aect the
interest rate in the rest of the world) is to induce a change in the risk of holding domestic assets or
induce an expected change in the domestic exchange rate. This constraint can be developed further
by introducing the relationship between nominal interest rates and real interest rates developed
further as follows:
r = i e(Equation 6)

where e is the rate of ination expected during the term of the loan, r is the real interest rate on
which people base their decisions and the nominal interest rate is given by i. Using this relationship,
we can express domestic and foreign interest rates as
rd= id ed( Equation 7)
rf= if ef(Equation 8)
26

and then subtract (8) from (7) to obtain rd rf= (id if) (ed ef) (Equation 9)
which upon substitution of equation (4) gives
rd rf= + E (ed ef)= (ed E ef) (Equation 10)
The expression (edE ef) equals the expected rate of change of the real exchange rate where
the latter is dened as P d Pf= q.( Equation 11) Pd and Pf are the price levels of domestic and
foreign output. The real exchange rate q is the relative price of domestic output in terms of foreign
output where both prices are measured in domestic currency. Equation (10) can thus be rewritten as
rd rf= Eq (Equation 12) where E q is the expected rate of change in the domestic real exchange
rate.
The domestic real interest rate is thus constrained in relation to the foreign real interest rate by
rd= r f + Eq(Equation 13)

An expected rise in the real exchange rate (increase in the relative price of domestic output in terms
of foreign output) lowers the domestic real interest rate because it implies an increasing value of
domestic output in terms of foreign output and thus a future capital gain on domestic capital
relative to foreign capital. This makes domestically employed capital more valuable as
compared to foreign capital, raising its price and lowering the interest rate at which the future (non-
capital-gains) income from it is discounted. Equation (13) implies a constraint on the real interest
rate similar to the constraint on the nominal interest rate implied by equation (5). This
constraint says that the domestic authorities can aect the domestic real interest rate in two ways
by inducing a change in the risk of holding domestic capital, or by inducing a change in peoples
expectations about the future course of the real exchange rate. This assumes, of course, that the
domestic authorities have no control over the foreign interest rate. Finally, the relationships
between the nominal and real interest rates in the domestic and foreign economies, given by the
two countries Fisher equations,
I d= r d+ e d (Equation 14)
if= rf+ ef (Equation 15)
obtained by rearranging equations (7) and (8) implies that
I d if= (rd rf) + (ed ef) (Equation 16)
A change in the domestic relative to the foreign expected ination rate will lead to an equal change
in the domestic relative to the foreign nominal interest rate, assuming that real interest rates are
unaected.

3.4. Foreign Exchange Rate Forecasting
Technical forecasting - As in other forms of market forecasting, technical forecasting of exchange
rate movements involves statistical analysis of historical data, especially time series analysis as a
means of predicting future exchange rate movements.
Fundamental forecasting - This form of forecasting involves analysis of the fundamental factors
and relationships that affect exchange rate fluctuations: interest rates, inflation, and other
economic variables. Such analysis may employ linear regression and other statistical methods, but
based on an economic theoretical framework which assumes key economic factors affecting
exchange rates.
Market based forecasting - This form of forecasting relies on the expectations as to future
exchange rate movements built into the pricing of market instruments such as foreword and futures
rates for various time periods versus spot rates.
Mixed forecasting - Mixed forecasting simply involves using several of the above types of
forecasting rather than relying on the validity of one approach.
27

Fixed exchange rate system - Rate fixed by government as constant or forced to stay within
defined narrow limits.
Freely floating exchange rate system - Exchange rates determined purely by market forces.
Incidental imbalances efficiently resolved by market forces.
Managed float exchange rate system - Blend of the above that can be termed a not perfectly free
floating rate system.
Pegged exchange rate system - The currency of one country is set equal to or as a fixed percentage
of another country's currency (generally a major stable currency like the US dollar
Practice Questions

1.Consider a world with two countries, domestic and foreign, in both of which ve units of output
are produced for every unit of capital stock, broadly dened to include human capital, physical
capital, technology, knowledge, etc. Suppose that the domestic (and foreign) real exchange rate is an
immutable constant equal to 1.0. Suppose, further, that the residents of both the domestic and
foreign economies choose to hold one unit of nominal money balances for every two units of
nominal output, regardless of market interest rates. Finally, assume that no one in either economy
requires any premium to bear risk. What will be the eect on the nominal exchange rate, the
forward discount on the domestic currency and the domestic market interest rate of
a) An unanticipated (by the private sector) one-shot increase in the domestic
nominal money supply of 10 percent, brought about by the actions of the
domestic government?
b) A sudden and not previously predicted increase in the publics desired ratio
of nominal money to nominal income from 0.5 to 0.6?
c) An increase in the rate of growth of the domestic money supply, brought
about by pre-announced actions of the domestic government, from 0
percent per year to 10 percent per year?
d) How would your answers above change if it were the case that the publics
desired ratio of money to income falls in both countries when the nominal
interest rate increases?
e) In the above cases, does the forward discount adjust to equal the
domestic/foreign interest rate dierential or does the domestic/foreign
interest rate dierential adjust to equal the forward discount?

2. Suppose that the exchange rate between U.S. dollars and Swedish krona is $1 = 6.6565 krona.
How many dollars can 10,000 krona be exchanged for?
3. You will be vacationing in Belgium and wish to take with you $500 in Belgian francs. If the
exchange rate is $1 = 29.14 Belgian francs, how many francs will you need?
4. Explain covered interest parity.
5. State the law of one price.
6. How does arbitrage ensure that the law prevails?
7. What is purchasing power parity? Why does PPP not appear to hold in the real world?
28

8. ALKMAR ICE SKATE COMPANY
a) Hans Brinker is Assistant Vice-President for marketing for Alkmar Ice Company. Alkmar does
all of its manufacturing in the Netherlands and then distributes worldwide through its sales
offices. World prices for foreign sales offices are set by the home office. Brinker is now
setting the price list for all U.S. sales offices, and needs prices set for the coming year.
(b) The currency spot rate is HA1.8935/$, with a one-year forward rate HA1.9207/$. The one-
year Eurocurrency deposit rates for Dutch guilders and U.S dollars are 6.0000% and 4.5000%,
respectively. Alkmars best selling professional figure skate, the Royal Silver Blade, is currently
priced at $350 to U.S. retailers. Current inflation estimates for the Netherlands and the United
States are both 3.00%. Alkmars policy is to try to absorb about 50% of all exchanger rate-
induced price increases, but pass along 100% of all exchange rate price decreases if possible. The
world skate business is competitive.
(c) Brinker phones you on Friday afternoon and explains that he will be on a business trip next
week, and you will therefore be responsible for setting the U.S. dollar prices for the coming year.
Your price list is due Monday morning at 10:00A.M.
9. Explain the concept of covered interest arbitrage, and the scenario necessary for it to be plausible.

(a) Assume the following information:
Quoted Price
Spot rate of Canadian dollar $ .80
90-day forward rate of Can. Dollar $ .79
90-day Canadian Interest rate 4%
90-day U.S interest rate 2.5%

Given the above information, what would be the yield (percentage return on the invested funds) to
a U.S. investor who used a covered interest arbitrage strategy?

Assume the investor had invested $1000, 000

(b) Based on the information in the previous question, what market forces would occur to eliminate any
further possibilities of covered interest arbitrage?
(c) Explain the concept of International Fisher Effect (IFE). What are the implications of IFE to firms with
excess cash that consistently invest in foreign treasury bills?


.




29

Chapter Four

Government Intervention in The Foreign Exchange
Market
Learning Outcomes
To describe the exchange rate systems used by various governments;
To explain how governments can use direct and indirect intervention to influence exchange
rates; and
To explain how government intervention in the foreign exchange market can affect
economic conditions
The foreign market
Figure 4.1. Impact of Government Actions on
Exchange Rates
Government Intervention
in
Foreign Exchange Market
Government
Monetary
and Fiscal Policies
Relative Interest
Rates
Relative Inflation
Rates
Relative National
Income Levels
International
Capital Flows
Exchange Rates
International
Trade
Tax Laws,
etc.
Quotas,
Tariffs, etc.
Government
Purchases & Sales
of Currencies

30

Government intervention in the foreign exchange markets comes in a number of ways. This
intervention can either be direct or indirect depending on the particular government
macroeconomic policy focus.
4.1. Exchange Rate Systems
Exchange rate systems can be classified according to the degree to which the rates are
controlled by the government.
Exchange rate systems normally fall into one of the following categories:
fixed
freely floating
managed float
pegged
4.1.2. Fixed Exchange system
In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only
within very narrow bands.
The Bretton Woods era (1944-1971) fixed each currencys value in terms of gold.
The 1971 Smithsonian Agreement which followed, merely adjusted the exchange rates and
expanded the fluctuation boundaries. The system was still fixed.
Pros: Work becomes easier for the MNCs.
Cons: Governments may revalue their currencies. In fact, the dollar was devalued more than
once after the U.S. experienced balance of trade deficits.
Cons: Each country may become more vulnerable to the economic conditions in other
countries.
4.1.3. In a freely floating exchange rate system, exchange rates are determined solely by market
forces.
Pros: Each country may become more insulated against the economic problems in other
countries.
Pros: Central bank interventions that may affect the economy unfavourably are no longer
needed
31

Pros: Governments are not restricted by exchange rate boundaries when setting new
policies.
Pros: Less capital flow restrictions are needed, thus enhancing the efficiency of the financial
market.
Cons: MNCs may need to devote substantial resources to managing their exposure to
exchange rate fluctuations.
Cons: The country that initially experienced economic problems (such as high inflation,
increasing unemployment rate) may have its problems compounded
4.1.4. In a managed (or dirty) float exchange rate system, exchange rates are allowed to move
freely on a daily basis and no official boundaries exist. However, governments may intervene to
prevent the rates from moving too much in a certain direction.
Cons: A government may manipulate its exchange rates such that its own country benefits at
the expense of others.
4.1.5 In a pegged exchange rate system, the home currencys value is pegged to a foreign
currency or to some unit of account, and moves in line with that currency or unit against other
currencies.
The European Economic Communitys snake arrangement (1972-1979) pegged the
currencies of member countries within established limits of each other.
Exposure of a Pegged Currency to Interest Rate Movements
A country that uses a currency board does not have complete control over its local interest
rates, as the rates must be aligned with the interest rates of the currency to which the local
currency is tied.
Note that the two interest rates may not be exactly the same because of different risks.
A currency that is pegged to another currency will have to move in tandem with that
currency against all other currencies.
So, the value of a pegged currency does not necessarily reflect the demand and supply
conditions in the foreign exchange market, and may result in uneven trade or capital flows
4.2. . Dollarization
Dollarization refers to the replacement of a local currency with U.S. dollars.
Dollarization goes beyond a currency board, as the country no longer has a local currency.
32

For example, Ecuador implemented dollarization in 2000.
Zimbabwe replaced its Zimbabwe dollar with a cocktail of currencies in 2008.x
4.3. A Single European Currency
In 1991, the Maastricht Treaty called for a single European currency. On Jan 1, 1999, the
Euro was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg,
Netherlands, Portugal, and Spain. Greece joined the system in 2001.
By 2012, the national currencies of the 12 participating countries will be withdrawn and
completely replaced with the euro.
Within the euro-zone, cross-border trade and capital flows will occur without the need to
convert to another currency.
European monetary policy is also consolidated because of the single money supply. The
Frankfurt-based European Central Bank (ECB) is responsible for setting the common
monetary policy.
The ECB aims to control inflation in the participating countries and to stabilize the euro
within reasonable boundaries.
The common monetary policy may eventually lead to more political harmony.
Note that each participating country may have to rely on its own fiscal policy (tax and
government expenditure decisions) to help solve local economic problems.
4.4. Government Intervention
Each country has a government agency (called the central bank) that may intervene in the foreign
exchange market to control the value of the countrys currency. In the United States, the Federal
Reserve System (Fed) is the central bank.
4.5. Central banks manage exchange rates
to smooth exchange rate movements,
to establish implicit exchange rate boundaries, and/or
to respond to temporary disturbances.
Often, intervention is overwhelmed by market forces. However, currency movements may
be even more volatile in the absence of intervention.
33

Direct intervention refers to the exchange of currencies that the central bank holds as
reserves for other currencies in the foreign exchange market.
4.6. Direct intervention is usually most effective when there is a coordinated effort among
central banks.
When a central bank intervenes in the foreign exchange market without adjusting for the
change in money supply, it is said to engaged in nonsterilized intervention.
In a sterilized intervention, treasury securities are purchased or sold at the same time to
maintain the money supply Central banks can also engage in indirect intervention by
influencing the factors that determine the value of a currency.
For example, the Fed may attempt to increase interest rates (and hence boost the dollars
value) by reducing the U.S. money supply.
Note that high interest rates adversely affect local borrowers.
Governments may also use foreign exchange controls (such as restrictions on currency exchange) as
a form of indirect intervention
4.7. Exchange Rate Target Zones
Many economists have criticized the present exchange rate system because of the wide
swings in the exchange rates of major currencies.
Some have suggested that target zones be used, whereby an initial exchange rate will be
established with specific boundaries (that are wider than the bands used in fixed exchange
rate systems).
The ideal target zone should allow rates to adjust to economic factors without causing wide
swings in international trade and fear in the financial markets.
However, the actual result may be a system no different from what exists today.
4.8. Intervention as a Policy Tool
Like tax laws and money supply, the exchange rate is a tool which a government can use to
achieve its desired economic objectives.
A weak home currency can stimulate foreign demand for products, and hence local jobs.
However, it may also lead to higher inflation.
34

A strong currency may cure high inflation, since the intensified foreign competition should
cause domestic producers to refrain from increasing prices. However, it may also lead to
higher unemployment.
Figure 4.2. Impact of Central Bank
Intervention
on an MNCs Value
( ) ( ) [ ]
( )

=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Direct Intervention
Indirect Intervention



Practice Questions
1. State and explain reasons why the Central Bank of Zimbabwe should use indirect intervention to
change the value of the local currency.
2. Should the Government of Zimbabwe allow its currency to float freely? What would be the
advantages of letting it currency float freely? What would be the disadvantages for this approach?






35

Chapter Five
Foreign Exchange Exposure Measurement and Management
Learning Outcomes
To be able to understand and discuss the MNCs exposure to exchange rate risk
To be able to understand the nature of transaction exposure and how it can be
measured
To be able to understand the nature of economic exposure and how it be measured
To be able to understand the nature of translation exposure and how it can be
measured.
To learn about commonly used methods of hedging the firms transaction exposure
To understand the various methods and hedging and their advantages and disadvantages.

KEY TERMS
EXCHANGE RATE EXPOSURE EXCHANGE RATE RISK
TRANSACTION EXPOSURE TRANSLATION EXPOSURE
ECONOMIC EXPOSURE ACCOUNTING EXPOSURE
OPERATIONAL RISK CURRENCY FUTURES
MARKET HEDGE FORWARD RATE CONTRACT
FUTURES CONTRACT

5.1. Risks i n International Trade
It is an established argument that a firm can increase its market value by reducing the
variability of its cash flows (operational risk) and which in the case of exchange rate risk
hedging is instrumental.

While exchange rate risk is the major risk in international trade, there are other risks that are
not related to foreign exchange rate risk. These are:

i) Default Risk: The exporter may not ship the goods at all after the sale contract i.e.
fails to perform the contract (performance risk)

ii) Delivery Risk: The goods shipped may not conform to the contracts specifications.

iii) Credit Risk: The importer may fail to pay, or pay too little or too late.

iv) Transfer risk: The importers country may have run out of the foreign exchange
reserves by the time the payment is due and therefore no
remittance

5.1.2. Transaction exposure : is a type of foreign exchange risk faced by companies that
engage in international trade. It is the risk that exchange rate
fluctuations will change the value of a contract before it is settled.
Transaction exposure is also called transaction risk.

Transaction exposure is the risk that foreign exchange rate changes
will adversely affect a cross
A cross
A business contract may extend over a period of months. Foreign
exchange rates can fluctuate instantaneously. Once a cross
contract has be
a specific amount of money, subsequent fluctuations in exchange
rates can change the value of that contract.

Managing Transaction Exposure
This model illustrates the impact of transaction exposure on
cash flows

FIGURE 5.1 Impact of Transaction Exposure on MNC Cashflows.
Transaction exposure exists when the future cash transactions of a firm are affected by exchange
rate fluctuations. When transaction exposure exists, the firm
Identify its degree of transaction exposure,
Decide whether to hedge its exposure, and
Choose among the available hedging techniques if it decides on hedging.
A company that has agreed to but not yet settled a cross
exposure as any change to the exchange rate will impair the
time between the agreement and the settlement of the contrac
associated with exchange rate fluctuation


36
Transaction exposure is the risk that foreign exchange rate changes
will adversely affect a cross-currency transaction before it is settled.
A cross-currency transaction is one that involves multiple currencies.
A business contract may extend over a period of months. Foreign
exchange rates can fluctuate instantaneously. Once a cross
contract has been agreed upon, for a specific quantity of goods and
a specific amount of money, subsequent fluctuations in exchange
rates can change the value of that contract.
Managing Transaction Exposure
This model illustrates the impact of transaction exposure on
cash flows (see Figure 5.1).
Impact of Transaction Exposure on MNC Cashflows.
Transaction exposure exists when the future cash transactions of a firm are affected by exchange
rate fluctuations. When transaction exposure exists, the firm faces three major tasks:
Identify its degree of transaction exposure,
Decide whether to hedge its exposure, and
Choose among the available hedging techniques if it decides on hedging.
A company that has agreed to but not yet settled a cross-currency contract that has transaction
as any change to the exchange rate will impair the companys cash flows. The greater the
time between the agreement and the settlement of the contract Equation, the greater the risk
associated with exchange rate fluctuations.
Transaction exposure is the risk that foreign exchange rate changes
ncy transaction before it is settled.
currency transaction is one that involves multiple currencies.
A business contract may extend over a period of months. Foreign
exchange rates can fluctuate instantaneously. Once a cross-currency
en agreed upon, for a specific quantity of goods and
a specific amount of money, subsequent fluctuations in exchange
This model illustrates the impact of transaction exposure on MNC


Transaction exposure exists when the future cash transactions of a firm are affected by exchange

ct that has transaction
The greater the
, the greater the risk
37

5.1.2.1. Transaction Risk Example

For example, lets say a domestic company signs a contract with a foreign company. The contract
states that the domestic company will ship 1,000 units of product to the foreign company and the
foreign company will pay for the goods in 3 months with 100 units of foreign currency. Assume the
current exchange rate is: 1 unit of domestic currency equals 1 unit of foreign currency. The money
the foreign company will pay the domestic company is equal to 100 units of domestic currency.

The domestic company, the one that is going to receive payment in a foreign currency, now has
transaction exposure. The value of the contract is exposed to the risk of exchange rate fluctuations.

The next day the exchange rate changes and then remains constant at the new exchange rate for 3
months. Now one unit of domestic currency is worth 2 units of foreign currency. The foreign
currency has devalued against the domestic currency. Now the value of the 100 units of foreign
currency that the foreign company will pay the domestic company has changed the payment is
now only worth 50 units of domestic currency.

The contract still stands at 100 units of foreign currency, because the contract specified payment in
the foreign currency. However, the domestic firm suffered a 50% loss in value.

5.2. Hedging Transaction Risk

A company engaging in cross-currency transactions can protect against transaction exposure by
hedging. The company can protect against the transaction risk by purchasing foreign currency, by
using currency swaps, by using currency futures, or by using a combination of these hedging
techniques. Any one of these techniques can be used to fix the value of the cross-currency contract
in advance of its settlement.
5.2.1. A forward contract or simply a forward is an agreement between two parties to buy
or sell an asset at a certain future time for a certain price agreed today. This is in
contrast to a spot contract, which is an agreement to buy or sell an asset today. It
costs nothing to enter a forward contract. The party agreeing to buy the underlying
asset in the future assumes a long position, and the party agreeing to sell the asset in
the future assumes a short position. The price agreed upon is called the delivery
price, which is equal to the forward price at the time the contract is entered into.
The price of the underlying instrument, in whatever form, is paid before control of
the instrument changes. This is one of the many forms of buy/sell orders where the
time of trade is not the time where the securities themselves are exchanged.
The forward price of such a contract is commonly contrasted with the spot price,
which is the price at which the asset changes hands on the spot date. The difference
between the spot and the forward price is the forward premium or forward
discount, generally considered in the form of a profit, or loss, by the purchasing
party.
Forwards, like other derivative securities, can be used to hedge risk (typically
currency or exchange rate risk), as a means of speculation, or to allow a party to take
advantage of a quality of the underlying instrument which is time-sensitive.
5.2.2. Money Market Hedges
38

Objective: borrow/lend to lock in home currency value of cash flow

1. Expected Inflow of Foreign Currency: Borrow present value of the foreign currency at a
fixed interest and convert it into home currency. Deposit the home currency at a fixed
interest rate. When the foreign currency is received, use it to pay off the foreign
currency loan.
Expected Outflow of Foreign Currency: Determine PV of the foreign currency to be paid
(using foreign currency interest rate as the discount rate). Borrow equivalent amount of
home currency (considering spot exchange rate). Convert the home currency into PV
equivalent of the foreign currency (in the spot market now) and make a foreign currency
deposit on payment day, withdraw the foreign currency deposit (which by the time
equals the payable amount) and make payment.
Example
A US firm is expected to pay A$300,000 to an Australian supplier 3 months from now.
A$ interest rate is 12% and US$ interest rate is 8%. Spot rate is 0.60A$/US$.
PV of A$: 300,000/(1+.12/4) = A$291,262.14 Borrow (291,262.14X0.60) US$174,757.28
and convert it to A$291,262.14 at spot rate (0.60/US$) Use the A$ to make an A$
deposit which will grow to A$300,000 in 3 months. Pay this A$300,000 on due date Pay
{174,757.28X(1+0.8/4)} US$178,252.43 with interest for settling the US$ loan.
5.3. Conditions for Use of Money Market Hedge strategy
Firms have access to money market for different currencies
The dates of expected future cash flows and money market transaction maturity match
offshore currency deposits or Eurocurrency deposits are main money market hedge
instruments.
Comparison: Forward and Money Market Hedge The covered interest parity implies
that a firm cannot be better off using money market hedge compared to forward hedge.
In reality, firms find use of forward contracts more profitable than use of money market
instruments, because firms:
Borrow at a rate> inter-bank offshore lending rate
Put deposits at a rate< inter-bank offshore deposit rate.
A closely related contract is a futures contract; they differ in certain respects. Forward contracts are
very similar to futures contracts, except they are not marked to market, exchange traded, or defined
on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in
margin requirements like futures - such that the parties do not exchange additional property
securing the party at gain and the entire unrealized gain or loss builds up while the contract is open.
A forward contract arrangement might call for the loss party to pledge collateral or additional
collateral to better secure the party at gain
39

5.4. Measuring and Managing Accounting Exposure.
Accounting exposure, also called translation exposure, refers to the change in the value of a
subsidiary, as given by its financial statements in the reporting currency, when these
statements are translated into the currency of the parent firm.
5.4.1. Concept of Accounting Exposure

Exposure = Total unexpected change on Financial Position of a firm, as measured in
home Current, at Time (t)
Unexpected change in S
t
(Spot exchange rate at time, t)
Equivalently, we can say:
Unexpected effect on the financial position of a firm
= Exposure x Unexpected change in S
t
(Spot exchange rate at a time, t)
Two concepts need to be reconciled here.
Financial position from purely accounting position means Accounting Value Net worth as
given by the financial statements of a firm.
Whereas from the economic exposure perspective, financial position is interpreted to mean
the present value of a firms future cash flows.

In other words, translation exposure measures the impact of exchange rate movement on the
accounting value of a firms foreign subsidiary, while economic exposure measures the effect on
the cash flows and consequently its impact on the market value of a firm.
5.4.2. Translating Financial Statements :
If some of the subsidiaries of a firm are located abroad, their financial statements are
typically maintained in terms of the ruling foreign currency.
It therefore becomes necessary to translate these financial statements into the parents
financial reporting currency for consolidation purposes.
Reasons:
(i) Taxes in the parents home country on income earned by the foreign subsidiary are payable
in home currency. This means that the foreign income has to be translated into the home
currency. Thus, translation exposure, even though it deals with accounting data, can have
an impact on a firms CASH FLOWS through its effect on the taxable amounts
(ii) Most countries require consolidation of the parents and subsidiarys financial statements
for financial reporting purposes.
(iii) A firm may also need to translate the financial statements of foreign subsidiaries in order to
consolidate data in order to make investment and financial decisions.
40

(iv) In order to make performance measures comparable, foreign data need to be translated into
a common currency. Decisions to promote or fire managers are also based on performance.
(v) To value the entire firm, one needs far more than just accounting data. Still, valuation is
often partially based on accounting values; i.e. accounting value serves as a reference point.

If the discounted cash flow value of the entire firm turns out to be four times its book value,
one should surely take a closer look at both types of information. This information might
suggest creative accounting.
5.4.3. Different Translation Methods:
Firms would like to hedge translation exposure to eliminate or reduce the swings in reported
profits resulting from translation effects. This exposure depends on the rules used to
translate the accounts of the subsidiary into the currency of the parent firm.
Approaches:
Basically, there are four different translation methods and philosophies. Each method has a
set of rules for translating items in the balance sheet and the income statement. The rules
for translating items in the income statement are quite similar across the different methods.
Hence we shall concentrate on items reported in the Balance Sheets and rules for their
translation.
(i) The Current/Non-Current Method:
According to this method, current assets and liabilities in the balance sheet are translated at
the current exchange rate as on the translation date, while non-current assets (items) i.e.
long term debt are translated at the historical rate (the rate at which they entered the
companys books)
The logic behind this is that the value of short-term assets and liabilities already reflect
movements in the foreign exchange rate and fluctuate with the exchange rate movements.
Long term assets and liabilities, in contrast, will not be realized in the short-run and by the
time they are realized, the current exchange rate change may turn out to have been undone
by the latter. This is to say the long term realization value of long term assets and liabilities
is very uncertain.
Thus accountants who favour Current/non-current method agree that long term items
should be recorded at the historical exchange rate when they were acquired.
Under the current/non-current method, translation at the current rate is restricted to only
the short term assets and liabilities. This means a measure of the translation exposure is
generally given by the difference between short term assets and liabilities, i.e. Net Working
Capital.
Illustration on Current/Non-Current Method:
41


Historical Historical Current Change
Bal. Sheet Exchange rate Exchange in
Rate Value



(R) (0.333 $/R) (0.300 $/R) ($)
Assets:
Cash & securities 1 000 333 300
A/R 1 000 333 300
Inventory 1 000 333 300
Plant & Equipment 5 000 1 625 1 625
Total (a) 8 000 2 624 2 530 -99

Liabilities:
A/P 500 166.5 150
Short term Debt 2 000 666 600
Long term Debt 2 400 780 780
Total Debts (b) 4 900 1612.5 1 530 -82.5

Net Worth
(a) (b) 3 100 1 011.5 -16.5

Alternatively, this 16.5 US$ can easily be calculated thus

Effect of exchange rate change under the Current/Non-Current Method
42


= (Exposure) X s

= [Current Assets Current Liabilities] X s.

= Net Working Capital X s
= 500 X (0.300 0.333) = - $16.5
To translate the subsidiarys income statement, the current/non-current method uses an
average exchange rate over the period, assuming that cash flows come evenly over the
period except for incomes or costs corresponding to non-current items like depreciation of
assets. These are translated at the same rate as the corresponding balance sheet item to
which they are related.
(ii) The Monetary/Non-Monetary Method:
This method translates monetary items in the Balance sheet using the current exchange
rate. When using this method, the values of claims or liabilities denominated in a dropping
foreign currency drop by the same percentage.
Thus, according to this method, we should adjust only the monetary (not real) assets and
liabilities: items whose values are already fixed by contracts to reflect the changes in
exchange rate.
Effect of Exchange rate Change under the Monetary/Non-Monetary Method: Using the
Previous Example:
= [Exposure] x s
= [Financial Assets Financial liabilities] X s
= $[2 000 4 900] X (0.300 0.333) = + $95.7
To translate the subsidiarys income statement, the monetary/non-monetary method uses
an average exchange rate of the period except for income or costs corresponding to non-
monetary sources like depreciation. These are translated at the same rate as the
corresponding Balance Sheet item.
(iii) The Temporal Method:
The temporal method of translating the financial statements of a foreign subsidiary is similar
to the Monetary/Non-Monetary method. The main difference between the two methods is
that, under the monetary system, inventory is translated at the historical exchange rate,
because it is considered a non-monetary item.
However, under the Temporal Method, inventory may be translated at the current exchange
rate, if it is recorded in the Balance Sheet at the current market prices.
43

By making translation movements part of the reported earnings, it does not allow
firms to maintain reserves for currency losses. Thus, if translation gains and losses
are reflected in the income statement of the firm and it can lead to large swings in
reported earnings (incomplete sentence).
(iv) The Current Rate Method:

This so far is the simplest approach for translating financial statements.
According to the current rate method, all balance sheet items are translated at the current
exchange rate.
Typically, exchange gains are reported separately in a special equity account on the
parents balance sheet, thus avoiding large variations in reported earnings, and
these unrealized gains are not taxed.
Income statement is translated (all items) at the current exchange rate or the average
exchange rate of the reporting period. The first method is chosen for consistency with the
balance sheet translation.
However, the second method is recommended on the argument that expenses that have
been made gradually over the year should be translated at the average exchange rate.
Profits, are realized gradually over the years, and should be translated at an average
exchange rate.
Illustration Using the Previous figures:
Effect of exchange rate change under the current rate method:
= [Exposure] x s
= [Total Assets Total Liabilities] x s
= [Net Worth] x s
= 3 100 x (0.300 0.333)
= -$102.3
5.3. 0 Conclusion on Translation Accounting:
Many accounting regulating bodies favour the current rate method. The International
Accounting Standards Committee (IFRSC) also has endorsed the current rate method.
However, the IFRSC can only provide recommendations; it has no statutory power to impose
accounting rules anywhere.
- However, this still does not answer our dilemma.
44

Although one can still argue that the choice of the translation method does not
affect reality, except possibly through its effects on taxable profits, so that the whole
issue is, basically, a non-issue.
- Accounting data are already complicated enough, so that the current rate method is
probably a good choice, given its simplicity and internal consistency.
- Accounting exposure is limited by the fact that assets are valued at historical costs.

- Accounting exposure is limited by the fact that it is an incomplete measure of the
risks that a firm faces because accounting exposure ignores operating exposure.
That is, there is no room in the financial statements of a firm to reflect the operating
exposure that a firm faces.
- The translation effect can be part of reported income (and, therefore,
taxable/deductible). If the company records the translation gain or loss in the
income statement, in case of a loss, its durability has to be proved to the tax
authorities, otherwise they are disallowed.

Practice Questions
1.Jos Corporation is a South African-based firm and needs R600 000 to finance one of its expansion
projects. It has no business in Switzerland but is considering one year financing in Swiss Francs, because
the annual interest rate would be 5% in Switzerland versus 9% in South Africa. The spot rate of the Swiss
Franc is presently R .6200, while the forward rate is R .6436.
(i) Can Jose benefit by borrowing Swiss Francs and simultaneously purchasing Francs one-year forward
to cover the same contract to avoid exchange rate risk? Explain.

(ii) Assume that Jose does not cover its exposure and expects that the Swiss Franc will appreciate by 5%,
3%, 2% and 1% all with an equal probability of occurrence. Use this information to determine the
probability distribution of the effective financing rates. Show how these would appear in a normal
distribution curve.
(iii) Based on your findings above, should Jose finance with Swiss Francs? Explain.
(iv) Assume that Jose does not cover its exposure and uses the forward rate to forecast the future
spot rate. Determine the expected effective financing rate and comment whether Joses should
finance with Swiss Francs. Explain.

2. Why would a firm consider hedging net payables or net receivables with currency options rather
than forward contracts? What are the disadvantages of hedging with currency options as
opposed to futures contracts?
3. Explain how a firm trying to reduce its transaction exposure can use currency diversification.

45

4. Carbondale Company expects to receive SF 500, 000 in a years time from Switzerland. The existing
spot rate of the Swiss Franc is $.60/1SF. The one-year forward rate of the Swiss franc is $.62/1SF.
Carbondale created a probability distribution for the future spot rate on SF in one year as follows:

Future Spot rate Probability

$.61 20%
$.63 50%
$.67 30%

Assume that a one-year put option (an option to sell) on francs is available, with an exercise price of
$.63/1SF and a premium (price) of $.04 per unit. One-year call option on francs is available with an
exercise price of $.60/1SF and a premium of $.03 per unit. Assume the following money Market
rates.
US SWITZERLAND
Deposit rates 8% 5%
Borrowing rates 9% 6%
Given the above information, determine whether a forward hedge, money market hedge, or a
currency options hedge would be most appropriate (cost effective). Then compare the most
appropriate hedge strategy to an un-hedged strategy, and decide whether Carbondale should hedge
its payables position anyway.










46

Chapter Six

Country Risk Analysis

Learning Outcomes

To identify the common factors used by MNCs to measure a countrys political risk and
financial risk;
To explain the techniques used to measure country risk; and
To explain how the assessment of country risk is used by MNCs when making financial
decisions

KEY TERMS
COUNTRY RISK SOVEREIGN RISK
POLITICAL RISK TRANSFER RISK
COUNTRY RISK RATING


6.1. Country risk refers to the risk of investing in a country, dependent on changes in the business
environment that may adversely affect operating profits or the value of assets in a specific country.
For example, financial factors such as currency controls, devaluation or regulatory changes, or
stability factors such as mass riots, civil war and other potential events contribute to companies'
operational risks. This term is also sometimes referred to as political risk; however, country risk is a
more general term, which generally only refers to risks affecting all companies operating within a
particular country.
6.2. Sovereign Risk concerns whether a government will be unwilling or unable to meet its loan
obligations, or is likely to renege on loans it guarantees. Sovereign risk can relate to transfer risk in
that a government may run out of foreign exchange due to unfavourable developments in its
balance of payments. It also relates to political risk in that a government may decide not to honour
its commitments for political reasons. The Country Risk Analysis literature designates sovereign risk
as a separate category because a private lender faces a unique risk in dealing with a sovereign
government. Should the government decide not to meet its obligations, the private lender
realistically cannot sue the foreign government without its permission.
Sovereign-risk measures of a government's ability to pay are similar to transfer-risk measures.
Measures of willingness to pay require an assessment of the history of a government's repayment
performance, an analysis of the potential costs to the borrowing government of debt repudiation,
and a study of the potential for debt rescheduling by consortiums of private lenders or international
institutions. The international setting may further complicate sovereign risk. In a recent example,
IMF guarantees to Brazil in late 1998 were designed to stop the spread of an international financial
crisis. Had Brazil's imbalances developed before the Asian and Russian financial crises, Brazil
probably would not have received the same level of support, and sovereign risk would have been
higher.
47

6.3. Political risk analysis providers and credit rating agencies use different methodologies to
assess and rate countries' comparative risk exposure. Credit rating agencies tend to use quantitative
econometric models and focus on financial analysis, whereas political risk providers tend to use
qualitative methods, focusing on political analysis. However, there is no consensus on methodology
in assessing credit and political risks.
Political Risk concerns risk of a change in political institutions stemming from a change in
government control, social fabric, or other noneconomic factors. This category covers the potential
for internal and external conflicts, expropriation risk and traditional political analysis. Risk
assessment requires analysis of many factors, including the relationships of various groups in a
country, the decision-making process in the government, and the history of the country. Insurance
exists for some political risks, obtainable from a number of government agencies (such as the
Overseas Private Investment Corporation in the United States) and international organizations (such
as the World Bank's Multilateral Investment Guarantee Agency).
Few quantitative measures exist to help assess political risk. Measurement approaches range from
various classification methods (such as type of political structure, range and diversity of ethnic
structure, civil or external strife incidents), to surveys or analyses by political experts. Most services
tend to use country experts who grade or rank multiple socio-political factors and produce a written
analysis to accompany their grades or scales. Company analysts may also develop political risk
estimates for their business through discussions with local country agents or visits to other
companies operating similar businesses in the country. In many risk systems, analysts reduce
political risk to some type of index or relative measure. Unfortunately, little theoretical guidance
exists to help quantify political risk, so many "systems" prove difficult to replicate over time as
various socio-political events ascend or decline in importance in the view of the individual analyst.
6.4. Transfer risk measures typically include the ratio of debt service payments to exports or to
exports plus net foreign direct investment, the amount and structure of foreign debt relative to
income, foreign currency reserves divided by various import categories, and measures related to the
current account status. Trends in these quantitative measures reveal potential imbalances that could
lead a country to restrict certain types of capital flows. For example, a growing current account
deficit as a percent of GDP implies an ever-greater need for foreign exchange to cover that deficit.
The risk of a transfer problem increases if no offsetting changes develop in the capital account.
6.5. Exchange Risk is an unexpected adverse movement in the exchange rate. Exchange risk
includes an unexpected change in currency regime such as a change from a fixed to a floating
exchange rate. Economic theory guides exchange rate risk analysis over longer periods of time (more
than one to two years). Short-term pressures, while influenced by economic fundamentals, tend to
be driven by currency trading momentum best assessed by currency traders. In the short run, risk for
many currencies can be eliminated at an acceptable cost through various hedging mechanisms and
futures arrangements. Currency hedging becomes impractical over the life of the plant or similar
direct investment, so exchange risk rises unless natural hedges (alignment of revenues and costs in
the same currency) can be developed.
Many of the quantitative measures used to identify transfer risk also identify exchange rate risk
since a sharp depreciation of the currency can reduce some of the imbalances that lead to increased
transfer risk. A country's exchange rate policy may help isolate exchange risk. Managed floats, where
the government attempts to control the currency in a narrow trading range, tend to possess higher
risk than fixed or currency board systems. Floating exchange rate systems generally sustain the
lowest risk of producing an unexpected adverse exchange movement. The degree of over- or under-
valuation of a currency also can help isolate exchange rate risk.
48

6.6. Predicting Political Stability
Macro political risk analysis is still an emerging field of study. Political scientists in academia,
industry, and government study country risk for the benefit of multinational firms, government
foreign policy decision makers, and defence planners.
Political risk studies usually include an analysis of the historical stability of the country in question,
evidence of present turmoil or dissatisfaction, indications of economic stability, and trends in
cultural and religious activities. Data are usually assembled by reading local newspapers, monitoring
radio and television broadcasts, reading publications from diplomatic sources, tapping the
knowledge of outstanding expert consultants, contacting other businesspeople who have had recent
experience in the host country, and impressive on site-visits.
Despite this impressive list of activities, the prediction track record of business firms, the diplomatic
service, and the military has been spotty at best. When one analyzes trends, whether in politics or
economics, the tendency is to predict an extension of the same trends. It is a rare forecaster who is
able to predict a cataclysmic change in direction. Who predicted the overthrow of the Shah of Iran
and the ascent of a dogmatic theocratic government there? Who predicted the overthrow of
Ferdinand Marcos in the Philippines? Indeed, who predicted the collapse of communism in the
Soviet Union and its Eastern European satellites? Who predicted the invasion of Kuwait by Iraq in
1990? Who, in early 1997 could have predicted what would happen to Hong Kong after mid-1997?
What does the difference between the Euro-American policy of imposing sanctions on Myanmar
(formerly Burma) and ASEANs policy of engagement imply for the continuation of Myanmars
military regime or its replacement by the National League for Democracy Party of Aung San Suu Kyi?
The Myanmar military placed Aung San Suu Kyi under house arrest in July 1989, the year before her
party won an open and free election, and kept her there until 1995. Is a confrontation policy more or
less likely than a policy of accommodation to lead to policy and economic liberalization?
6.7 Predicting Firm Specific
From the viewpoint of a multinational firm, assessing the policy stability of a host country is only the
first step, since the real objective is to anticipate the effect of political changes on activities of a
specific firm. Indeed, different foreign firms operating within the same country may have very
different degrees of vulnerability to changes in host country policy or regulations. One does not
expect a Kentucky Fried Chicken franchise to experience the same risk as a Fort manufacturing plant.
The need of firm-specific analyses of political risk has led to a demand for tailor-made studies
undertaken in-houseby professional political risk analysis. This demand is heightened by the
observation that outside professional risk analysts rarely even agree on the degree of macro political
risk that exists in any set of countries.
In-house political risk analysts relate the micro-risk attributes of specific countries to the particular
characteristics and vulnerabilities of their client firms. Dan Haendel notes that the framework for
such analysts depends on such attributes as the ratio of a firms foreign to domestic investments,
the political sensitivity of the particular industry, and the degree of diversification. Mineral extractive
frims, manufacturing firms, multinational banks, private insurance companies, and worldwide hotel
chains are all exposed in fundamentally different ways to politically inspired restrictions.
49

Even with the best possible firm-specific analysts, multinational firms cannot be sure that the
political or economic situation will not change. Thus it is necessary to plan protective steps in
advance to minimize the risk of damage from unanticipated changes. Possible protective steps can
be divided into two categories, both of which have financial implications although they are not
finance
6.7. Establishing operation strategies after the investment is made
6.7.1. Negotiating the Environment prior to investment
The best approach to political risk management is to anticipate problems and negotiate
understandings beforehand. Different cultures apply different ethics to the question of honouring
prior contracts, especially when they were negotiated with a previous administration.
Nevertheless, renegotiation of all conceivable areas of conflict provides a better basic for a
successful economic future for both parties than does overlooking the possibility that divergent
objectives will evolve over time.
6.7.2. Negotiating investment agreement
An investment agreement should spell out policies on financial and managerial issues, including the
following:
The basis on which fund flows, such as dividends, management fees, royalties, patent fees,
and loan repayments, may be remitted.
The basis for setting transfer prices.
The right to export to third-country markets.
Obligations to build, or fund, social and economic overhead projects such as schools,
hospitals, and retirement systems.
Methods of taxation, including the rate, the type of taxation, and how the rate base is
determined.
Access to host country capital markets, particularly for long-term borrowing.
Permission for 100% foreign ownership versus required local ownership (joint venture)
participation.
Price controls, if any, applicable to sales in the host country markets.
Requirements for local sourcing versus import of raw materials and components.
Permission to use expatriate managerial and technical personnel, and to bring them and
their personal possessions into the country free of exorbitant visa charges or import duties.
Provisions for arbitration of disputes.
Provisions for planned divestment, should such be required, indicating how the going
concern will be valued and to whom it will be sold.
6.7.3. Investment and Insurance Guarantees.
Multinational firms can sometimes transfer political risk to a home country public agency through an
investment insurance and guarantee programme. Many developed countries have such programmes
to protect investments by their nationals in developing countries.
The U.S investment insurance and guarantee program is managed by the government owned
Overseas Private Investment Corporation (OPIC), organized in 1969 to replace earlier programmes.
OPICs stated purpose is to mobilize and facilitate the participating of U.S private capital and skills in
50

the economic and social progress of less developed friendly countries and areas, there by
complementing the developmental assistance of the United States. OPIC offers insurance coverage
for four separate types of political risk, which have their own specific definitions for insurance
purposes:
Inconvertibility is the risk that the investor will not be able to convert profit, royalties, fees,
or other income, as well as the original capital invested, into dollars.
Expropriation is the risk that the host government takes a specific step which, for one year,
prevents the investor or the foreign affiliate from exercising effective control over use of
the property.
War, revolution, insurrection and civil strife coverage applies primarily to the damage of
physical property of the insured, although in some cases inability of a foreign affiliate to
repay a loan because of a war may be covered.
Business income coverage provides compensation for loss of business income resulting
from events of political violence that directly cause damage to the assets of a foreign
enterprise.
6.7.4. Operating Strategies after investment decision.
Although an investment agreement creates obligations on the part of both the foreign investor and
the host government, conditions change and the agreements are often revised in the light of such
changes. The changed conditions may be economic, or they may result from political changes within
the host government. The firm that sticks rigidly to the legal interpretation of its original agreement
may well find the host government first applies pressure in areas not covered by the agreement and
then possibly reinterprets the agreement to conform to the political reality of that country.
6.9 Techniques of Assessing Country Risk
A checklist approach involves rating and weighting all the identified factors, and then
consolidating the rates and weights to produce an overall assessment.
The Delphi Technique involves collecting various independent opinions and then averaging
and measuring the dispersion of those opinions.
Quantitative analysis techniques like regression analysis can be applied to historical data to
assess the sensitivity of a business to various risk factors.
Inspection visits involve traveling to a country and meeting with government officials, firm
executives, and/or consumers to clarify uncertainties.
Often, firms use a variety of techniques for making country risk assessments.
For example, they may use a checklist approach to develop an overall country risk rating,
and some of the other techniques to assign ratings to the factors considered.
6.10. Developing A Country Risk Rating
A checklist approach will require the following steps:
Assign values and weights to the political risk factors.
Multiply the factor values with their respective weights, and sum up to give the political risk
rating.
Derive the financial risk rating similarly.
Assign weights to the political and financial ratings according to their perceived importance.
Multiply the ratings with their respective weights, and sum up to give the overall country risk
rating
51

Practice Questions
1.Explain how the theory of comparative advantage relates to the need for international
business.

2.Shahs Corporation of the U.S. owns 100% of Finley of Finland. This year Finley - Finland
earned Fim 102 000 000 equal to US $24 000 000 at the current exchange rate of Fim
4.25/1$. The exchange rate is not expected to change in the near future.
Shahs U.S. wants to transfer half of the Finnish earnings to the United States and wonders which is the
best way to remit this sum is:
3.By a cash dividend of US $12 000 000, or By a cash dividend of US $6 000 000 and a royalty of US $6 000
000 .
4.Finish income taxes are 28% and 5% withholding tax, while the US income taxes are 34%. Which of
these methods would you recommend for Shahs to repatriate its earnings?
Give your reasons.
5.Zen Corporation considered establishing a subsidiary in Zenland; it performed a country risk analysis to
help make the decision. It first retrieved a country risk analysis performed about one year earlier, when it
planned to begin a major exporting business to Zenland firms. Then it updated the analysis by
incorporating all current information on the Key variables that were used in that analysis, such as
Zenland's willingness to accept imports, its existing quotas, and existing tariff laws. Is this country risk
analysis adequate? Explain.
6.It was sometimes argued that projects considered for China could be assessed using a higher discount
rate to capture the possibility of new government policies in order to capture this risk when estimating a
project's NPV. Would this method properly distinguish between projects in China that would be
worthwhile and those that will not?
8.Describe the possible errors involved in assessing country risk. In other words, explain why country risk
analysis is always not accurate.
9.Explain an MNCs strategy of diversifying projects internationally in order to maintain a low level of
overall country risk.
10.Explain some methods of reducing exposure to existing country risk, while maintaining the same
amount of business within a particular country.
11.How could a country risk assessment be used to adjust a projects required rate of return?
Alternatively, how can such an assessment be used to adjust a projects estimated cash flow?








52

Chapter Seven
International Treasury Management and Financing

Learning Outcomes
To explain the difference between a subsidiary perspective and a parent perspective in
analyzing cash flows;
To explain the various techniques used to optimize cash flows.
To explain common complications in optimizing cash flows.
To explain the potential benefits and risks of foreign investments.
KEY TERMS

CENTRALIZED CASH MANAGEMENT DECENTRALIZED CASH MANAGEMENT
BLOCKED FUNDS OPTIMIZING CASH FLOWS
HEDGING STRATEGY TREASURY MANAGEMENT
INTERNATIONAL WORKING CAPITAL
7.1.0.. Cash Flow Analysis:
The viability of any international transaction should be assessed from both the host perspective and
also the parent company perspective. This chapter analyses treasury management and short term
international financing
7.1.1 Subsidiary Perspective
The management of working capital has a direct influence on the amount and timing of cash flow :
inventory management
accounts receivable management
cash management
liquidity management
Subsidiary Expenses
International purchases of raw materials or supplies are more likely to be difficult to manage
because of exchange rate fluctuations, quotas, etc.
If the sales volume is highly volatile, larger cash balances may need to be maintained in order
to cover unexpected inventory demands.
Subsidiary Revenue
International sales are more likely to be volatile because of exchange rate fluctuations,
business cycles, etc.
Looser credit standards may increase sales (accounts receivable), though often at the
expense of slower cash inflows
Subsidiary Dividend Payments
Forecasting cash flows will be easier
overhead charges) to be sent to the parent are known in advance and denominated in the
subsidiarys currency.
7.1.2. Centralized Cash Management
While each subsidiary is managing its own working capital, a
group is needed to monitor, and possibly manage, the parent
cash flows.
International cash management can be segmented into two functions:
optimizing cash flow movements, and
Investing excess cash.

Figure 7.1 shows the movement of cash in an international company.

Figure 7.1 The movement of cash in a multinational


The centralized cash management division of an MNC cannot always accurately forecast the events
that may affect parent- subsidiary or inter
53
Looser credit standards may increase sales (accounts receivable), though often at the
expense of slower cash inflows
Forecasting cash flows will be easier if the dividend payments and fees (royalties and
overhead charges) to be sent to the parent are known in advance and denominated in the
Centralized Cash Management
While each subsidiary is managing its own working capital, a centralized cash management
group is needed to monitor, and possibly manage, the parent-subsidiary and inter
International cash management can be segmented into two functions:
optimizing cash flow movements, and
Figure 7.1 shows the movement of cash in an international company.
movement of cash in a multinational company.
The centralized cash management division of an MNC cannot always accurately forecast the events
subsidiary or inter-subsidiary cash flows.
Looser credit standards may increase sales (accounts receivable), though often at the
if the dividend payments and fees (royalties and
overhead charges) to be sent to the parent are known in advance and denominated in the
centralized cash management
subsidiary and inter-subsidiary

The centralized cash management division of an MNC cannot always accurately forecast the events
54

It should, however, be ready to react to any event by considering any potential adverse impact on
cash flows, and how to avoid such adverse impacts.
7.2. Techniques to Optimize Cash Flows
7.2.1. Accelerating Cash Inflows o
The more quickly the cash inflows are received, the more quickly they can be invested or
used for other purposes.
Common methods include the establishment of lockboxes around the world (to reduce mail
float) and preauthorized payments (direct charging f a customers bank account).
7.2.2.Minimizing Currency Conversion Costs
Netting reduces administrative and transaction costs through the accounting of all
transactions that occur over a period to determine one net payment.
A bilateral netting system involves transactions between two units, while a multilateral
netting system usually involves more complex interchanges.
7.2.3. Managing Blocked Funds
A government may require that funds remain within the country in order to create jobs and
reduce unemployment.
The MNC should then reinvest the excess funds in the host country, adjust the transfer
pricing policy (such that higher fees have to be paid to the parent), borrow locally rather
than from the parent, etc.
7.2.4. Managing Inter-subsidiary Cash Transfers
A subsidiary with excess funds can provide financing by paying for its supplies earlier than is
necessary. This technique is called leading.
Alternatively, a subsidiary in need of funds can be allowed to lag its payments. This
technique is called lagging.
7.2.5. Complications in Optimizing Cash Flows
Company-Related Characteristics
When a subsidiary delays its payments to the other subsidiaries, the other
subsidiaries may be forced to borrow until the payments arrive.
Government Restrictions
Some governments may prohibit the use of a netting system, or periodically prevent
cash from leaving the country.
Characteristics of Banking Systems
The abilities of banks to facilitate cash transfers for MNCs may vary among
countries.
The banking systems in different countries usually differ too.
55

7.2.6. Investing Excess Cash
Excess funds can be invested in domestic or foreign short-term securities, such as
Eurocurrency deposits, bills, and commercial papers.
Sometimes, foreign short-term securities have higher interest rates. However, firms must
also account for the possible exchange rate movements.
Centralized Cash Management
Centralized cash management allows for more efficient usage of funds and possibly higher
returns.
When multiple currencies are involved, a separate pool may be formed for each currency.
The investment securities may also be denominated in the currencies that will be needed in
the future.
7.2.7 Implications of Interest Rate Parity (IRP)
A foreign currency with a high interest rate will normally exhibit a forward discount that
reflects the differential between its interest rate and the investors home interest rate.
However, short-term foreign investing on an uncovered basis may still result in a higher
effective yield.
7.2.8 Use of the Forward Rate as a Forecast
If IRP exists, the forward rate can be used as a break-even point to assess the short-term
investment decision.
The effective yield will be higher if the spot rate at maturity is more than the forward rate at
the time the investment is undertaken, and vice versa. Figure 7.2 shows the impact of
international cash management on an MNCs value.
Figure 7.2. Impact of International Cash
Management
on an MNCs Value
( ) ( ) [ ]
( )

=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Returns on International
Cash Management



56



Practice Questions

1.Assume the following information for BIM, a local bank:
Value of Mozambiquean Metical in Rands = R0.2857
Value of Swaziland Emalangeni in Rands = R0.0952
Value of Mozambiquean Metical in Swaziland Emalangeni = R3.300
a. Given the information above, evaluate if triangular arbitrage is possible.
b. If so, explain the steps that would reflect arbitrage , and compute the profit from this strategy if
you had 100 000 Meticals to use.
c. Under what conditions would an MNC subsidiary consider use of a leading strategy to reduce
transactions exposure?
d. When is it optimal for an MNC to rely on centralised currency hedge mechanisms?
2. Explain how the following strategies can be used by a Zimbabwean company faced with a
situation of appreciating dollar.
(a) Lagging
(b) Leading
(c) Off setting
3. Discuss the advantages of centralized cash management for a multinational corporation.










57



Chapter Eight

Multinational Cost of Capital & Capital Structure

Learning Outcomes
To explain how corporate and country characteristics influence an MNCs cost of capital;
To explain why there are differences in the costs of capital across countries; and
To explain how corporate and country characteristics are considered by an MNC when it
establishes its capital structure.
KEY TERMS
INTERNATIONAL COST OF CAPITAL INTERNATIONAL CAPITAL MARKETS
BANKRUPTCY CAPITAL ASSET PRICING MODEL

8.1. Cost of Capital
A firms capital consists of equity (retained earnings and funds obtained by issuing stock) and debt
(borrowed funds). The cost of equity reflects an opportunity cost, while the cost of debt is reflected
in interest expenses. Firms want a capital structure that will minimize their cost of capital, and hence
the required rate of return on projects.
A firms weighted average cost of capital
kc
= (
D
) kd (

1

_

t

) + (
E
) ke

D + E D + E

where Kc Cost of Capital
D is the amount of debt of the firm
E is the equity of the firm
k
d
is the before-tax cost of its debt
t is the corporate tax rate
k
e
is the cost of financing with equity

58

The interest payments on debt are tax deductible. However, as interest expenses increase, the
probability of bankruptcy will increase too. It is favourable to increase the use of debt financing until
the point at which the bankruptcy probability becomes large enough to offset the tax advantage of
using debt. Figure 8.1. shows the trade-off between debt ratio and cost of capital.
Debts Tradeoff
Fig 8.1 Cost of Capital
C
o
s
t

o
f

C
a
p
i
t
a
l
Debt Ratio

8.2. Determinants of MNCs Cost of Capital
The cost of capital for MNCs may differ from that for domestic firms because of the following
differences.
8.2.1. Size of Firm. Because of their size, MNCs are often given preferential treatment by creditors.
They can usually achieve smaller per unit flotation costs, too.
8.2.2. Access to International Capital Markets. MNCs are normally able to obtain funds through
international capital markets, where the cost of funds may be lower.
8.2.3. International Diversification. M NCs may have more stable cash inflows due to international
diversification, such that their probability of bankruptcy may be lower.
8.2.4. Exposure to Exchange Rate Risk. MNCs may be more exposed to exchange rate fluctuations,
such that their cash flows may be more uncertain and their probability of bankruptcy higher.
8.2.5. Exposure to Country Risk. MNCs that have a higher percentage of assets invested in foreign
countries are more exposed to country risk.


59

Fig 8.2. Cost of Capital for MNCs
Possible
access to low-
cost foreign
financing
Preferential
treatment from
creditors
Greater access
to international
capital markets
Larger size
International
diversification
Exposure to
exchange rate
risk
Exposure to
country risk
Cost of
capital
Probability of
bankruptcy

8.3. Methods of calculating the MNCs Cost capital
The capital asset pricing model (CAPM) can be used to assess how the required rates of return of
MNCs differ from those of purely domestic firms.
According to CAPM, k
e
= R
f
+ b (R
m
R
f
)
where k
e
= the required return on a stock
R
f
= risk-free rate of return
R
m
= market return
b = the beta of the stock
A stocks beta represents the sensitivity of the stocks returns to market returns, just as a projects
beta represents the sensitivity of the projects cash flows to market conditions.
The lower a projects beta, will be the lower its systematic risk, and its required rate of return, since
its unsystematic risk can be diversified away.
8.4. Costs of Capital across Countries
The cost of capital may vary across countries, such that: MNCs based in some countries may have a
competitive advantage over others; MNCs may be able to adjust their international operations and
sources of funds to capitalize on the differences; and MNCs based in some countries may have a
more debt-intensive capital structure
The cost of debt to a firm is primarily determined by O the prevailing risk-free interest rate of the
borrowed currency and O the risk premium required by creditors.
The risk-free rate is determined by the interaction of the supply and demand for funds. It may vary
due to different tax laws, demographics, monetary policies, and economic conditions.
60

The risk premium compensates creditors for the risk that the borrower may be unable to meet its
payment obligations. The risk premium may vary due to different economic conditions, relationships
between corporations and creditors, government intervention, and degrees of financial leverage.
Although the cost of debt may vary across countries, there is some positive correlation among
country cost-of-debt levels over time.

A countrys cost of equity represents an opportunity cost what the shareholders could
have earned on investments with similar risk if the equity funds had been distributed to
them.
The return on equity can be measured by the risk-free interest rate plus a premium that
reflects the risk of the firm.
A countrys cost of equity can also be estimated by applying the price/earnings multiple to a
given stream of earnings.
A high price/earnings multiple implies that the firm receives a high price when selling new
stock for a given level of earnings. So, the cost of equity financing is low.
8.5. Using the Cost of Capital for Assessing Foreign Projects

O Derive NPVs based on the Weighted Average Cost of Capital (WACC.)
The probability distribution of NPVs can be computed to determine the probability
that the foreign project will generate a return that is at least equal to the firms
WACC.
O Adjust the WACC for the risk differential.
The MNC may estimate the cost of equity and the after-tax cost of debt of the funds
needed to finance the project.
8.6. The MNCs Capital Structure Decision
The overall capital structure of an MNC is essentially a combination of the capital structures
of the parent body and its subsidiaries.
The capital structure decision involves the choice of debt versus equity financing, and is
influenced by both corporate and country characteristics.
8.6.1. Corporate Characteristics
Stability of cash flows. MNCs with more stable cash flows can handle more debt.
Credit risk. MNCs that have lower credit risk have more access to credit.
Access to retained earnings. Profitable MNCs and MNCs with less growth may be able to
finance most of their investment with retained earnings.
8.6.2. Country Characteristics
Stock restrictions. MNCs in countries where investors have less investment opportunities
may be able to raise equity at a lower cost.
Interest rates. MNCs may be able to obtain loanable funds (debt) at a lower cost in some
countries.
Strength of currencies. MNCs tend to borrow the host country currency if they expect it to
weaken, so as to reduce their exposure to exchange rate risk
61

Country risk. If the host government is likely to block funds or confiscate assets, the
subsidiary may prefer debt financing.
Tax laws. MNCs may use more local debt financing if the local tax rates (corporate tax rate,
withholding tax rate, etc.) are higher.
8.6.3 .Interaction Between Subsidiary and Parent Financing Decisions
Increased debt financing by the subsidiary
A larger amount of internal funds may be available to the parent.
The need for debt financing by the parent may be reduced.
The revised composition of debt financing may affect the interest charged on debt as well as
the MNCs overall exposure to exchange rate risk
Reduced debt financing by the subsidiary

A smaller amount of internal funds may be available to the parent.
The need for debt financing by the parent may be increased.
The revised composition of debt financing may affect the interest charged on debt as well as
the MNCs overall exposure to exchange rate risk.

Amount of Internal Amount of
Local Debt Funds Debt
Host Country Financed by Available Financed
Conditions Subsidiary to Parent by Parent
Higher Country Risk Higher Higher Lower
Lower Interest Rates Higher Higher Lower
Expected Weakness
Higher Higher Lower
of Local Currency
Blockage of Funds Higher Higher Lower
Higher Taxes Higher Higher Lower
Fig 8.3 Interaction Between
Subsidiary and Parent Financing
Decisions


8.7. Using a Target Capital Structure on a Local versus Global Basis
An MNC may deviate from its local target capital structure as necessitated by local
conditions.
However, the proportions of debt and equity financing in one subsidiary may be adjusted to
offset an abnormal degree of financial leverage in another subsidiary.
Hence, the MNC may still achieve its global target capital structure
62

The volumes of debt and equity issued in financial markets vary across countries, indicating
that firms in some countries (such as Japan) have a higher degree of financial leverage on
average.
However, conditions may change over time. In Germany for example, firms are shifting from
local bank loans to the use of debt security and equity markets.
Fig 8.4 Impact of Multinational Capital
Structure Decisions on an MNCs Value
( ) ( ) [ ]
( )

=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Parents Capital Structure
Decisions






Practice Questions

1.Illustrate the impact on a firms financing costs using a potentially stronger vehicle currency, as
against a potentially weaker vehicle currency for a Zimbabwean-based firm in sourcing funds from
abroad.

2.Seminole, Inc., is a US-based company and is considering issuing a Mark-denominated bond at its
present coupon rate of 7%, even though it has no income in Mark cash flows to cover the bond
payments. It has simply been attracted to the low financing rate, since dollar bonds issued in the
United States would have a coupon rate of 12%.

Assume that either bond would have a four-year maturity and could be issued at par value.
Seminole needs to borrow $10 million. Therefore it will issue either dollar bonds with a par value of
$10 million or DM. bonds with a par value of 20 million. The spot rate of the Mark is $.50/1DM.
63

Seminole has forecasted the Marks value at the end of each of the next four years, when coupon
payments are to be paid thus.

Year End Exch. Rate of the DM
1 $.52
2 $.56
3 $.58
4 $.53

Determine the expected annual cost of financing with Mark. Should Seminole Corporation issue
bonds denominated in dollars or in Marks? Explain.

















64

Chapter Nine
Foreign Direct Investment


Learning Outcomes
To describe common motives for initiating direct foreign investment (DFI); and
To illustrate the benefits of international diversification.
To explain how DFI can help increase value of an MNC.
FOREIGN DIRECT INVESTMENT INTERNATIONAL DIVERSIFICATION
INTERNALISATION LOCAL SOURCING
FACILITY LOCATION

Foreign direct investment (FDI) is a measure of foreign ownership of productive assets, such as
factories, mines and land. Increasing foreign investment can be used as one measure of growing
economic globalization.
9.1. Motives for DFI
DFI can improve profitability and enhance shareholder wealth, either by boosting revenues or
reducing costs.
9.1.2 Revenue-Related Motives
Attract new sources of demand, especially when the potential for growth in the home country
is limited
. Exploit monopolistic advantages, especially for firms that possess resources or skills not
available to competing firms.
React to trade restrictions.
9.1.3. Cost-Related Motives
Fully benefit from economies of scale, especially for firms that utilize much machinery.
Use cheaper foreign factors of production.
Use foreign raw materials, especially if the MNC plans to sell the finished product back to the
consumers in that country.
React to exchange rate movements, such as when the foreign currency appears to be
undervalued. DFI can also help reduce the MNCs exposure to exchange rate fluctuations.
65

Diversify sales/production internationally.

The optimal method for a firm to penetrate a foreign market is partially dependent on the
characteristics of the market.
For example, if the consumers are used to buying domestic products, then licensing
arrangements or joint ventures may be more appropriate.
Before investing in a foreign country, the potential benefits must be weighed against the costs
and risks.
As conditions change over time, some countries may become more attractive targets for DFI,
while other countries become less attractive
9.2..Benefits of International Diversification
The key to international diversification is to select foreign projects whose performance levels
are not highly correlated over time.
An MNC may not be insulated from a global crisis, since many countries will be adversely
affected.
However, as can be seen from the 1997-98 Asian crisis, an MNC that had diversified among the
Asian countries might have fared better than if it had focused on one country. Even better
would be diversification among the continents.
As more projects are added to a portfolio, the portfolio variance should decrease on average,
up to a certain point.
However, the degree of risk reduction is greater for a global portfolio than for a domestic
portfolio, due to the lower correlations among the returns of projects implemented in
different economies.
Figure 9.1 shows the benefits of diversification. As the number of projects increase, the project
specific risk is reduced.
Fig 9.1 Portfolio Risk Reduction Effect.
9.3 Incentives for FDI
Foreign direct investment incentives may take the following forms:
low corporate tax and income tax
tax holidays
other types of tax concessions
preferential tariffs
special economic zones
investment financial subsidies
soft loan or loan guarantees
free land or land subsidies
relocation & expatriation subsidies
job training & employment subsidies
infrastructure subsidies
R&D support
derogation from regulations (usually for very large projects)
9.4 Host Government View of DFI
For the government, the ideal DFI solves problems such as unemployment and lack of
technology without taking business away from the local
The government may provide incentives to encourage the forms of DFI that it desires, and
impose preventive barriers or conditions on the forms of DFI that it does not want.
The ability of a host government to attract DFI is dependent on the country
resources, as well as government regulations and incentives.
Common incentives offered by the host government include tax breaks, discounted rent for
land and buildings, low-interest loans, subsidized energy, and reduced environmental
restrictions.
66
Foreign direct investment incentives may take the following forms:
[citation needed
income tax rates
other types of tax concessions
investment financial subsidies
guarantees

relocation & expatriation subsidies
job training & employment subsidies
derogation from regulations (usually for very large projects)

For the government, the ideal DFI solves problems such as unemployment and lack of
technology without taking business away from the local firms.
The government may provide incentives to encourage the forms of DFI that it desires, and
impose preventive barriers or conditions on the forms of DFI that it does not want.
The ability of a host government to attract DFI is dependent on the countrys markets and
resources, as well as government regulations and incentives.
Common incentives offered by the host government include tax breaks, discounted rent for
interest loans, subsidized energy, and reduced environmental

citation needed]

For the government, the ideal DFI solves problems such as unemployment and lack of
The government may provide incentives to encourage the forms of DFI that it desires, and
impose preventive barriers or conditions on the forms of DFI that it does not want.
s markets and
Common incentives offered by the host government include tax breaks, discounted rent for
interest loans, subsidized energy, and reduced environmental
67

Common barriers imposed by the host government include the power to block a
merger/acquisition, foreign majority ownership restrictions, excessive procedure and
documentation requirements (red tape), and operational conditions
Fig 9.2. Impact of DFI Decisions on an MNCs
Value
( ) ( ) [ ]
( )

=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
DFI Decisions on
Type of Business and Location



Practice Questions

1. Describe some potential benefits to the MNC as a result of direct foreign investment (DFI). To
what extent do they apply to FDI investment in Zimbabwe.?
2. Why would the Government of Zimbabwe provide MNCs with incentives to undertake DFI in its
country?
3. Discuss all the components, explaining the impact of foreign direct investment on the value of the
MNC.
4. Why do companies still invest in countries with high risk indicators?




68

Chapter Ten

Multinational Capital Budgeting Decisions


Learning Outcomes
To compare and understand the capital budgeting analysis of MNCs subsidiary versus that
of a parent.
To understand how multinational budgeting can be utilised to evaluate the viability of an
international project.
To understand how to assess project risk in an international context.
To how the corporate and country characteristics affect an MNCs cost of capital.
To understand the reasons for differing costs of capital in different countries.
KEY TERMS

MULTINATIONAL CAPITAL BUDGETING DOMESTIC PROJECT
FOREIGN PROJECT MULTIPLE SOURCE BORROWING

10.1. Capital budgeting theoretical framework.
Capital budgeting for a foreign project uses the same theoretical framework as domestic capital
budgeting. What are the basic steps in domestic capital budgeting? Multinational capital budgeting,
like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with
prospective long-term investment projects. Multinational capital budgeting techniques are used in
traditional FDI analysis, such as the construction of a manufacturing plant in another country, as well
as in the growing field of international mergers and acquisitions. The MNC uses capital budgeting
analysis to evaluate its international projects by comparing the costs and benefits of projects.
Capital budgeting, which involves the discounting of incremental project cash flows to arrive at the
project's net present value, is more complex in a multinational environment. This is due to such
problems as the difference in perspective between foreign subsidiary and parent and other
problems specific to the differing laws, business and cultural constraints of the countries involved.
The cost of capital of the MNC is important for capital budgeting decisions and as a determiner of
the value of the MNC as a whole. The MNC strives to utilize a capital structure that can minimize its
cost of capital by optimal use of capital funding opportunities (debt and equity) available to the MNC
globally.
Capital budgeting for a foreign project uses the same theoretical framework as domestic capital
budgetingwith a few very important differences. The basic steps are:
1) Identify the initial capital invested or put at risk.
69

2) Estimate cash flows to be derived from the project over time, including an estimate of the
terminal or salvage value of the investment.
3) Identify the appropriate discount rate for determining the present value of the expected cash
flows.
4) Apply traditional capital budgeting decision criteria such as net present value (NPV) and internal
rate of return (IRR) to determine the acceptability of or priority ranking of potential projects.
10.2. Domestic Project Appraissal Versus Foreign Project
Capital budgeting for a foreign project is considerably more complex than the domestic case. Several
factors contribute to this greater complexity:
Parent cash flows must be distinguished from project cash flows. Each of these two types of
flows contributes to a different view of value.
Parent cash flows often depend on the form of financing. Thus, we cannot clearly separate
cash flows from financing decisions, as we can in domestic capital budgeting.
Additional cash flows generated by a new investment in one foreign subsidiary may be in
part or in whole taken away from another subsidiary, with the net result that the project is
favourable from a single subsidiarys point of view but contributes nothing to worldwide
cash flows.
The parent must explicitly recognize remittance of funds because of differing tax systems,
legal and political constraints on the movement of funds, local business norms, and
differences in the way financial markets and institutions function.
An array of nonfinancial payments can generate cash flows from subsidiaries to the parent,
including payment of license fees and payments for imports from the parent.
Managers must anticipate differing rates of national inflation because of their potential to
cause changes in competitive position, and thus changes in cash flows over a period of time.
Managers must keep the possibility of unanticipated foreign exchange rate changes in mind
because of possible direct effects on the value of local cash flows, as well as indirect effects
on the competitive position of the foreign subsidiary.
Use of segmented national capital markets may create an opportunity for financial gains or
may lead to additional financial costs.
Use of host-government subsidized loans complicates both capital structure and the parents
ability to determine an appropriate weighted average cost of capital for discounting
purposes.
Managers must evaluate political risk because political events can drastically reduce the
value or availabilityof expected cash flows.
Terminal value is more difficult to estimate because potential purchasers from the host,
parent, or third countries, or from the private or public sector, may have widely divergent
perspectives on the value to them of acquiring the project.
10.3. Project versus parent valuation.
Why should a foreign project be evaluated both from a project and parent viewpoint? A
strong theoretical argument exists in favour of analyzing any foreign project from the
viewpoint of the parent. Cash flows to the parent are ultimately the basis for dividends to
70

stockholders, reinvestment elsewhere in the world, repayment of corporate-wide debt, and
other purposes that affect the firms many interest groups.
However, since most of a projects cash flows to its parent, or to sister subsidiaries, are
financial cash flows rather than operating cash flows, the parent viewpoint usually violates a
cardinal concept of capital budgeting, namely, that financial cash flows should not be mixed
with operating cash flows. Often the difference is not important because the two are almost
identical, but in some instances a sharp divergence in these cash flows will exist.
Evaluation of a project from the local viewpoint serves some useful purposes, but it should
be subordinated to evaluation from the parents viewpoint. In evaluating a foreign projects
performance relative to the potential of a competing project in the same host country, we
must pay attention to the projects local return.
Almost any project should at least be able to earn a cash return equal to the yield available
on host government bonds with a maturity the same as the projects economic life, if a free
market exists for such bonds. Host government bonds ordinarily reflect the local risk-free
rate of return, including a premium equal to the expected rate of inflation. If a project
cannot earn more than such a bond yield, the parent firm should buy host government
bonds rather than invest in a riskier project.
Host country inflation. How should an MNE factor host country inflation into its evaluation
of an investment proposal? Inflation is factored into the expected cash flows of the project
rate of return. Relative inflation affects the expected exchange rate due to purchasing power
parity.
10.4. Production and Logistics Strategies
Production and logistic policies to enhance bargaining position include local sourcing, location of
facilities, control of transportation, and control of technology.
10.4.1. Local Sourcing
Host governments may require foreign firms to purchase raw materials and components locally as a
way to maximize value-added and increase local employment. From the viewpoint of the foreign
firm trying to adapt to host country goals, local sourcing reduces political risk, albeit at a trade-off
with other factors. Local strikes or other turmoil may shut down the operation: in addition, such
issues as quality control, high local prices because of lack of economies of scale, and unreliable
delivery schedules become important. Often the foreign firm acquires lower political risk only by
increasing financial and commercial risk.
10.4.2. Facility Location
Production facilities may be located so as to minimize risk. The natural location of different stages of
production may be resource-oriented, footloose or market-oriented. Oil, for instance, is drilled in
and around the Persian Gulf, Venezuela, and Indonesia. No choice exists for where this activity takes
place. Refining is footloose, whenever possible, oil companies have built refineries in politically safe
countries, such as Western Europe or small islands (such as Singapore or Curacao), even though
costs might be reduced by refining nearer the oil fields. They have traded reduced political risk and
financial exposure for possibly higher transportation and refining costs.
71

10.4.3. Control of Transportation
Control of transportation has been an important means to reduced political risk. Control of oil
pipelines that cross national frontiers, oil tankers, ore carriers, refrigerated ships, and railroads have
been used at times to influence the bargaining power of both nations and companies.
10.4.4. Control of Technology
Control of key patents and processes is a viable way to reduce political risk. If a host country cannot
operate a plant because it does not have technicians capable of running the process, or of keeping
up with changed technology, abrogation of an investment agreement with a foreign firm is unlikely.
This approach works best when the foreign firm is steadily improving its technology.
10.4.5. Marketing Strategies

Marketing techniques to enhance a firms bargaining position include control of markets, brand
names, and trademarks.
Control of markets is a common strategy to enhance a firms bargaining position. As effective as the
OPEC cartel was in raising the price received for crude oil by its member countries in the 1970s,
marketing was still controlled by the international oil companies; OPECs need of the oil companies
limited the degree to which its members could dictate terms.
Control of export markets for manufactured goods is also a source of leverage in dealings between
foreign-owned firms and host governments. The multinational firm would prefer to serve world
markets from sources of its own choosing, basing the decision on considerations of production cost,
transportation, tariff barriers, political risk exposure, and competition. The selling pattern that
maximizes long-run profits from the overall viewpoint of the worldwide firm rarely maximizes
exports, or value-added, from the perspective of the host countries. The contrary argument is that
self-standing local firms might never obtain foreign market share because they lack economies of
scale on the production side and are unable to market in foreign countries.
10.4.6. Brand names and trade mark control
Control of a brand name or trademark can have an effect almost identical to that of controlling
technology. It gives the multinational firm a monopoly on something that may or may not have
substantive value but quite likely represents value in the eyes of consumers. Ability to produce for
and market under a world brand name is valuable for local firms, and thus represents an important
bargaining attribute for maintaining an investment position.
10.4.7. Financing Strategies
Financial strategies can be adopted to enhance the continued bargaining position of a multinational
firm. Many of these tactics are covered elsewhere in this module , so for the moment it is sufficient
to list some of the more popular techniques.
Foreign affiliates can be financed with a thin equity base and a large proportion of local debt. If the
debt is borrowed from locally owned banks, host government actions that weaken the financial
viability of the firm also endanger local creditors.
72

If the firm must finance with foreign-source debt, it should borrow from banks in countries other
than its own home country. If, for example, debt is owned to banks in Tokyo, Frankfurt, London and
New York, influential institutions in a number of foreign countries have a vested interest in keeping
the borrowing affiliate financially strong. If the multinational is U.S.-owned, a fall out between the
United States and the host government is less likely to cause the local government to move against
the firm if it might lead to a default on creditors in other countries.

Practice Questions

1. Wolverine Corp presently has no existing business in Germany but is considering the establishment of a
subsidiary there. The following information has been gathered to help in the assessment of the project:

(a.) The initial investment required is DM 50 million. Given the existing spot rate of $.50 per Mark, this initial
investment in dollars is $25 million. In addition to the DM50 million initial investment on plant and
equipment, DM 20 million will be needed for working capital and will be borrowed by the subsidiary from a
German bank. The German subsidiary of Wolverine will pay interest only on the loan each year, at an
interest rate of 14% percent. The loan principal is to be paid in 10 years.

(b.) The project will be terminated at the end of year 4, when the subsidiary will be sold as a going concern.

(c.) The price, demand, and variable costs of the product in West Germany are as follows:

Year Price Demand Variable Cost

1 DM 500 35,000 units DM 30
2 DM 511 45,000 units DM 35
3 DM 530 55,000 units DM 40
4 DM 524 50,000 units DM 45

(d.) The fixed costs, such as overhead expenses, are expected to be DM 6 million per year.

(e.) The exchange rate of the Mark is expected to be $ .52 at the end of year 1; $.54 at the end of year 2; $.56
at the end of year 3 and $.59 at the end of the year 4.

73

(f.) The US government will impose an income tax of 30 percent while the German corporate tax is 28 percent.
In addition, the German government will impose a withholding tax of 10 percent on earnings remitted by
the subsidiary to the US. The US government currently has entered into an agreement with its German
counterpart aimed at eliminating double taxation and therefore will allow tax credits on the portion of
remitted earnings.

(g.) 80% of cash flows received by the subsidiary are to be sent to the parent at the end of each year. The
subsidiary will use its working capital to support her on-going operations.

(h.) The plant and equipment are to be depreciated over 10 years using the straight-line method.

(i.) In four years, the subsidiary is to be sold. Wolverine Corp. expects to receive DM 70 million after
subtracting capital gains taxes on selling the subsidiary.

(j.) Wolverine requires a 20 percent return on this project.

Required

1. Determine the Net Present Value of the project and comment whether Wolverine should accept this
project.

2. Assume that Wolverine decides to implement the project, using the above-proposed financing
arrangement. Also assume that after one year, a German firm offers Wolverine a price of $27 million
after taxes for the subsidiary and that Wolverines original forecasts for years 2, 3 and 4 have not
changed. Should Wolverine divest the subsidiary? Explain

3. Assume Wolverine used the originally proposed financing arrangements and that funds are blocked
until the subsidiary is sold. The funds to be remitted are reinvested at a rate of 6% (after taxes) until the
end of year 4 when the project is to be sold. How is the projects net present value affected?

4.Illustrate the impact on a firms financing costs using a potentially stronger vehicle currency, as against
a potentially weaker vehicle currency for a Zimbabwean-based firm in sourcing funds from abroad.

5.Seminole, Inc. is a US-based company and is considering issuing a Mark-denominated bond at its
present coupon rate of 7%, even though it has no income in Mark cash flows to cover the bond
payments. It has simply been attracted to the low financing rate, since dollar bonds issued in the
United States would have a coupon rate of 12%.

Assume that either bond would have a four-year maturity and could be issued at par value.
Seminole needs to borrow $10 million. Therefore it will issue either dollar bonds with a par value of
$10 million or DM. bonds with a par value of 20 million. The Spot rate of the Mark is $.50/1DM.
74

Seminole has forecasted the Marks value at the end of each of the next four years, when coupon
payments are to be paid thus.

Year End Exch. Rate of the DM

1 $.52
2 $.56
3 $.58
4 $.53

Determine the expected annual cost of financing with Mark. Should Seminole Corporation issue
bonds denominated in dollars or in Marks? Explain.
4. On September 24, 2001, Smith Chemical Company sold C$2500,000 of agricultural pesticides to
Hindustan Agri Chemical Company, payable in 3 months at, Metropolitan Bank, Manitoba. The sale was
denominated in Indian rupees at a time when the rupee traded at 36.56 rupees per Canadian dollar.
On 22nd October 2001, the Reserve Bank of India announced a 240 billion-rupee budget package
designed to repair its relations with the International Monetary Fund and to end uncertainty over its
ability to service its C$128 billion foreign debt. (At that time, India's foreign exchange reserves were
estimated at C$761 million, worth about four weeks of imports). The Reserve Bank's discount rate was
then raised 3 percentage points to 20%, and the rupee was devalued to 40.22 per C$.
a) What was the percentage amount of devaluation?
b) What was the dollar loss experienced by Smith Chemical Company? When was it experienced?
c) Was the loss described in part (b) of a transaction, translation, or operating nature? Explain your
answer.
d) What precaution should have been taken to ensure that such losses do not get repeated?

5. Why should capital budgeting for subsidiary projects be assessed from the parents perspective?

6. What additional factors deserve consideration in a multinational capital budgeting project that is not
normally relevant for a purely domestic project? Explain.

7. What are the limitations of using single-point estimates of exchange rate when carrying out
multinational capital budgeting?

8. Explain briefly how the result of country risk analyses is finally incorporated into a multinational capital
budgeting process.


75


Chapter Eleven

International Payments

Learning Outcomes
To describe the methods of payment for international trade;
To explain common trade finance methods; and
To describe the major agencies that facilitate international trade.

KEY TERMS

INTERNATIONAL PAYMENTS TRADE BILL
TRADE ACCEPTANCE TRANSFER RISK
DOCUMENTARY CREDIT BANKERS ACCEPTANCE
FACTORING COUNTER TARDE
COMPENSATION TRADE COUNTER PURCHASE TRADE
INCOTERMS
Introduction
In any international trade transaction, credit is provided by either the supplier (exporter),
the buyer (importer), one or more financial institutions, or any combination of the above.
The form of credit whereby the supplier funds the entire trade cycle is known as supplier credit.

11.1. Managing the Default and Transfer Risks:

Cash payment after delivery, which in a domestic business transaction is referred to as
selling goods on account or credit is a well-known tradition and an established standard
practice.

Internationally, the practice of shipping goods on an open account is also widely
accepted, especially between those parties who have a long-standing and positive business
relationship and when the transfer risk is negligible.

However, if the foreign customer is new and unknown to the exporter or importer, or
if his/her credit standing deteriorates, or if the customers country is short of foreign
exchange reserves, the exporter faces default and transfer risks. In these
circumstances, payment after delivery is rated poorly in terms of these risks.

76

11.2. Approaches in dealing with default and transfer risks:
11.2.1. Cash payment before shipping:

This is a case when the supplier ships the goods only after receiving payment from
the foreign customer. In contrast to the case where goods are shipped on open
account, now the importer bears the default and delivery risks.

In the same contract the exporter has shifted the following risks to the importer:
i) Delivery risk
ii) Credit risk and
iii) Transfer risk

The above discussed mode of payment is an extreme way in which the risks can be
shifted from the exporter to importer and vice-versa and stifles international trade.

Cash payment method shifts the trading risks from the exporter to the importer.
To reduce the bad sides of the above method of international trade settlement,
its variants are used.

11.2.2.Use of trade Bills:

The use of personal trade bills mitigates the delivery and default risks facing the
importer after making payments, since the importer will honour the bills when the
terms of the export contract are fully met. Similarly, the exporter can discount the
bill immediately and absolve himself from the contract.

A second issue in international trade is the financing of working capital. Normally
the mode of payment determines which party has provided which part of the
financing of exports. Unless one party can obtain financing at a cost below the
regular bank rates, the investment in working capital is usually financed through
short-term bank loans.

Bank loans for international trade are easily obtained, and at attractive interest
rates, if the payment involves a trade bill (Also known as a draft or a bill of
exchange).

A trade bill is like a summary invoice. If it is drawn on and accepted by the
importer, it is called a Trade Acceptance; however, a bill drawn on and
accepted by a bank is called a Bankers Acceptance.

In many ways an acceptance payable on sight is similar to a cheque because
it can be cashed in at any moment.

Further Trade Bills once accepted by the importer can be discounted and
traded. The discounting of the trade bills is done by commercial banks or by
specialized financial institutions (i.e. discount house).

For all good intentions, banks favour bills--especially export bills, and are
willing to discount them at attractive interest rates.

77


Personal trade bills, though extensively used, from the point of view of
credit risk and transfer risk, the instrument remains almost as risky as an
invoice. For instance:

- The drawee might not even accept the bill after taking delivery.
- Might default on it; or
- Might not have a license to remit foreign exchange.


Normally, the legal redress in case of default by either the exporters or the
importers is slow and costly because the two parties are governed by
different laws; thus, it is wise for the parties to compromise contracts and
sought proactive methods to avert these risks.

Thus credit and transfer risks cannot be solved and this has led to the evolution
of documentary payment modes.


In a bid to improve on the negative sides of the payment through personal bills,
we can improve the situation through documentary payments.

Fig 11.1. Documentary Credit
Procedure
Buyer
(Importer)
OSale Contract
Seller
(Exporter)
ODeliver Goods
O
Request
for Credit
Importers Bank
(Issuing Bank)
O
Documents
& Claim for
Payment
O
Present
Documents
O
Deliver
Letter of
Credit
OPresent
Documents
OSend Credit
Exporters Bank
(Advising Bank)
OPayment


11.3. Documentary Payment Modes With Bank Participation

Given the inadequacy of legal redress with personal trade bills, one would wish to
choose a mode of payment in which the risks are shared between (importers,
exporters and at times the intermediating finance institution), and that reduces both
the probability as well as the cost of default.

78

Such contracts usually involve at least one financial institution, which acts as a
trustee for the importers and exporters.

The role of banks is, as we shall see, similar to that of a trustee. The arrangement is
that the bank receives a set of documents rather than the goods themselves. The
importer and exporter have to agree on what documents will be required.


11.4. Documents against Payment:
Here the bank receives a set of documents as agreed by the parties and remits the same to
the other party goods are not involved. This provides a reasonable solution to the default
risk

Under documents against payment (D/P), the bank checks whether all documents listed in
the contract are present. If nothing is missing, the bank remits these documents to the
importer against payment that is, the importer receives the papers only when the agreed-
up price has been paid to the banker. The importer, being in possession of the documents,
can then claim the merchandise from a designated warehouse.

11.5 Documents against Acceptance:

A D/A is a variant of a D/P, but has a built-in feature to allow the exporter to obtain finance
to process the exports before shipment

From a pure financial angle, the drawback of D/P is that it precludes the use of bills, which in
the domestic commercial transactions are instrumental in financing working capital because
of the possibility of them be discounted and cash got immediately. For that reason, a variant
of D/P is D/A.
Under D/A, the documents will be sent to a remitting bank that will pass them to the
customer after satisfying themselves that everything is in order. The set of documents now
will include a bill drawn by the exporter on the importer.

If the set of documents is complete, the bank will remit the documents to the importer who
would signify his acceptance of the bill. As soon as the latter has accepted (signed) the bill,
the acceptance is sent back to the exporter, who may discount it immediately to get cash.

The main difference between a D/P and D/A is that the importer may still default after
taking possession of the goods in the contract and this becomes the risk of a D/A (see Figure
11.2).

79

Fig 11.2. Life Cycle of a Typical Bankers
Acceptance
8. Pay Discounted Value of BA
1- 7 : Prior to BA
1. Purchase
Order
Importer Exporter
5. Ship
Goods
Importers
Bank
2. Apply
for L/C
11.
Shipping
Documents
14. Pay
Face Value
of BA
10. Sign
Promissory
Note to Pay
6.
Shipping
Documents
& Time
Draft
4. L/C
Notification
9. Pay
Discounted
Value of
BA
7. Shipping Documents
&
Time Draft
Exporters
Bank
3. L/C
12. BA
Money Market
Investor
13. Pay Discounted Value of BA
16. Pay Face Value of BA
15. Present BA at Maturity
14- 16 : When BA
matures
8- 13 : When BA
is created


11.6. Obtaining a guarantee from the Importers Bank: the Letter of Credit.

An LC reduces the credit risk, default risk, transfer risk and delivery risks
involved in the D/P and D/A.

There is an obvious and simple way to resolve the default risk in a D/A arrangement. The
exporter can insist that the importer have the payment or bill guaranteed by his/her bank,
which also acts as the remitting bank. The exporter will insist on evidence to such a
commitment before sending any documents.
If, as is usually the case, the banks guarantee is conditional on receiving a set of
conformatory documents, this type of arrangement is called a documentary credit. Note
that in contrast to D/P or D/A payments, the receiving bank is now responsible for the
payment as soon as it accepts that the documents conform to the standard contract and
therefore is part and parcel of the export contract.

The L/C arrangement reduces the probability and cost of default. L/C arrangement is still far
from perfect. Occasionally, letters of credit turn out to be counterfeited or issued by banks
that, from their name and logo, look like branches of major international banks but are in
fact just minor local and useless banks. Finally, even if the issuing bank is sound, transfer
risk still exists. In managing all of the problems, the exporters own bank can play a useful
role.
The problem with the above letter of credit is that it can be a counterfeit letter of credit and
further it still does not solve the transfer risk. This problem requires an independent bank to
the importers bank to confirm the letter of credit.

11.7. Advised or Confirmed Letters of Credit
There are several ways in which an exporter can further reduce the default risk, even after
obtaining an L/C.

80

The exporter can ask the issuing bank to send the L/C to a designated bank trusted
by the exporter, called advisory bank. The advisory bank receives the L/C from the
issuing bank; its task is to check whether the bank exists and is in good financial
standing, whether the signatures are legitimate and signed by the banks manager
duelly authorized to do so.

- The exporter can also ask the importer to have the L/C confirmed by a bank located in
the exporters country, or at least confirmed by a well-known bank trusted by the
exporter. Under such an arrangement, the confirming bank will actually guarantee the
payment; that is, it will pay the exporter if the original issuing bank defaults, or if the
transfer is blocked.

Thus a confirmed L/C offers insurance against default on behalf of the issuing bank
against transfer risk

- The exporter can also have a bank-backed bill or the issuing bank accept discounting the
bill without recourse. This again shifts the transfer risk and default risks to the issuing
bank. This technique is called forfeiting implying discounting regular commercial
invoices on a non-recovery basis.

11.8. Other standard ways to cope with Default Risk:

A letter of credit is only but one of the many ways to insure against credit risks. Exporters
can also use factor companies, or they can buy insurance from export credit insurance
companies.

11.8.1. Factoring

This is a pure debt collection contract with recourse to the seller should the customer fail to
pay or without recourse to the client should the customer fail to pay.

A credit insurance agent is a factor who, over and above credit collection, also guarantees
payments should the customer default.

Accounts receivable financing; a factor can also finance the invoices, after the deduction of
interest (at the rate applicable on straight loans.)

Financing of insured invoices also eliminates foreign exchange risk.

Therefore factoring is similar to non-recourse discounting of bills, or forfeiting.
11.8.2.Credit Insurance

Virtually every country has a government agency that insures export credit and / or transfer
risk. Usually, if the exporters contract is with a foreign government institution, credit risks
and transfer risks are often not separate and one needs to insure both.

81

11.8.3.Export-Backed Financing:

Firms in a country experiencing a temporary shortage of hard currency may find it difficult to
import goods. In such a case, banks may grant advances to firms against the firms future
export proceeds. To ensure the safety of the loans, the lending bank typically adds two
clauses to the loan contract:

- The exporting firm must sell its export output forward.
- The buyer of the forward sale must pay the proceeds through the bank
When the payment is received, the bank withholds the amounts required to service its loan,
and pays out the balance to the exporting firm.

Export-backed finance means obtaining finance on the basis of anticipated
export proceeds.
11.8.4. Counter trade:

Counter-trade is viewed as a form of financial engineering, as it involves:

i) Selling;

ii) Buying; and

iii) Cleverly securing financing on such exports; this is because most of these
contracts invariably involve a delay between delivery and receipt of
payment.


The advantages of counter-trade are essentially the components packaged together such as:

- An opportunity to trade;
- Use of trade intermediaries;
- Obtaining finance and
- Risk shifting through forward trade/sub-contracting

There are several techniques / forms of carrying out counter-trade transactions.
11.8.5.Barter trade
Pure barter-trade consists of an exchange of goods for goods simultaneously or
within a short interval of time.

b) Compensation trade
Compensation trade is a type of barter where one of the flows is partly in goods and
partly in cash (hard currency). An L/C may be used to insure the cash component of
the transaction.

c) Counter Purchase trade:
This is closer to a standard trade than is the compensation trade. It consists of an
autonomous contract, i.e.;

82

- Purchase of one combine harvester against cash, and a second contract,
which is conditional on the first one.

- Purchase of goods from the first sales proceeds worth a given amount from
the initial contract.

d) Buy-Back
Here the exporting countrys firm builds a turn-key plant (and often also provides
training and management assistance often referred to as technological transfers)
and is paid in stated amounts of the plants output at stated intervals.

e) Switch Trade
This is similar to a negotiated counter-purchase contract. For example, a Canadian
exporter delivers a combine harvester and obtains the right to buy C$300, 000 worth
of the importer countrys goods within a stated period. Now, suppose the Canadian
company can utilize only C $200,000 worth of goods and finds it difficult to use the
C$100 000 balance. Under switch trade this balance can be sold to another firm or
to another trader usually at a discount.

11.8.6. Advantages of Counter trade:
o With asymmetric and proprietary information and bid-offer spreads for
transactions, the drafting, monitoring and implementation of one
contract is probably cheaper and easier than that of three separate but
interlinked contracts like:

Turnkey project;
The loan agreement; and
The long term sales contract;
Camouflaging the deal, a single packaged contract allows one to hide the
true revenues and costs of the component transactions.


Since counter trade involves several contracts in one, they are more
economical to draft. Further, because several contracts are crafted into one
contract, this enables the exporter to hide revenues and costs of individual
contracts components
11.9.. AGENCIES THAT MOTIVATE INTERNATIONAL TRADE:

Due to the inherent risks of international trade, insurance against various forms of
risk is desirable. Some agencies provide insurance or combine it with various loan-
support programmes or guarantees.

In the US, the prominent agencies providing these services are:

11.9.1 Export-Import Bank (Exim Bank)

The programmes of Exim Bank are designed to meet two broad objectives:

83

i) Assumes the underlying credit and country risk and encouraging private
lenders to finance export trade; and
ii) Provides direct loans to foreign buyers when private lenders are unwilling
to do so. These goals are broadly achieved through the provision of:
(a) Guarantees;
(b) Loans; and
(c) Insurance.

11.9.2.Export Credit Insurance:

A variety of short term and medium term insurance policies are available to
exporters, banks and other eligible applicants. Basically, all the policies provide
insurance protection against the risk of nonpayment by foreign buyers. Exim Bank
operates these policies.
i. If a foreign buyer fails to pay due to commercial reasons such as cash flow
problems or insolvency, the policy pays between 90 to 100% of the
insurance amount.
ii. If the failure is due to war or political reasons such as foreign exchange
controls, Exim Bank reimburses 100% of the insured amount.

11.9.3 Private Exchange Funding Corporation (PEFCO)

A consortium of commercial banks and industrial companies own this. Working
together with Exim Bank, PEFCO provides medium and long term fixed rate financing
to foreign buyers. Exim Bank guarantees all export loans made by PEFCO.
11.9.4 Overseas Private Investment Corporation (OPIC):

Is a self-sustaining federal agency responsible for insuring the direct US investments
in foreign countries against the risks of currency inconvertibility, expropriation and
other political risks

11.8. INCOTERMS
Language is one of the most complex and important tools of international trade. As in any complex
and sophisticated business, small changes in wording can have a major impact on all aspects of a
business agreement.
Word definitions often differ from industry to industry. This is especially true of global trade where
such fundamental phrases as "delivery" can have a far different meaning in the business than in the
rest of the world.
For business terminology to be effective, phrases must mean the same thing throughout the
industry. That is why the International Chamber of Commerce created "INCOTERMS" in 1936.
INCOTERMS are designed to create a bridge between different members of the industry by acting as
a uniform language they can use.
Each refers to a type of agreement for the purchase and shipping of goods internationally. There are
more than 13 different terms, each of which helps users deal with different situations involving the
84

movement of goods. For example, the term FCA is often used with shipments involving Ro/Ro or
container transport; DDU assists with situations found in intermodal or courier service-based
shipments.
INCOTERMS also deal with the documentation required for global trade, specifying which parties are
responsible for which documents. Determining the paperwork required to move a shipment is an
important job, since requirements vary so much between countries. Two items, however, are
standard: the commercial invoice and the packing list.
INCOTERMS were created primarily for people inside the world of global trade. Outsiders frequently
find them difficult to understand. Seemingly common words such as "responsibility" and "delivery"
have different meanings in global trade than they do in other situations.
In global trade, "delivery" refers to the seller fulfilling the obligation of the terms of sale or to
completing a contractual obligation. "Delivery" can occur while the merchandise is on a vessel on the
high seas and the parties involved are thousands of miles from the goods. In the end, however, the
terms wind up boiling down to a few basic specifics:


Costs: who is responsible for the expenses involved in a shipment at a given point in the
shipment's journey?
Control: who owns the goods at a given point in the journey?
Liability: who is responsible for paying damage to goods at a given point in a shipment's transit?
It is essential for shippers to know the exact status of their shipments in terms of ownership and
responsibility. It is also vital for sellers and buyers to arrange insurance on their goods while the
goods are in their "legal" possession. Lack of insurance can result in wasted time, lawsuits, and
broken relationships.
INCOTERMS can thus have a direct financial impact on a company's business. What is important is
not the acronyms, but the business results. Often companies like to be in control of their freight.
That being the case, sellers of goods might choose to sell CIF, which gives them a good grasp of
shipments moving out of their country, and buyers may prefer to purchase FOB, which gives them a
tighter hold on goods moving into their country.
In this glossary, we'll tell you what terms such as CIF and FOB mean and their impact on the trade
process. In addition, since we realize that most international buyers and sellers do not handle goods
themselves, but work through customs brokers and freight forwarders, we'll discuss how both fit
into the terms under discussion.
INCOTERMS are most frequently listed by category. Terms beginning with F refer to shipments
where the primary cost of shipping is not paid for by the seller. Terms beginning with C deal with
shipments where the seller pays for shipping. E-terms occur when a seller's responsibilities are
fulfilled when goods are ready to depart from their facilities. D terms cover shipments where the
shipper/seller's responsibility ends when the goods arrive at some specific point. Because shipments
are moving into a country, D terms usually involve the services of a customs broker and a freight
forwarder. In addition, D terms also deal with the pier or docking charges found at virtually all ports
and determining who is responsible for each charge.
85

Recently (2004) the ICC changed basic aspects of the definitions of a number of INCOTERMS; buyers
and sellers should be aware of this. Terms that have changed have a star alongside them.
EX-Works
One of the simplest and most basic shipment arrangements, places the minimum
responsibility on the seller with greater responsibility on the buyer. In an EX-Works
transaction, goods are basically made available for pickup at the shipper/seller's factory or
warehouse and "delivery" is accomplished when the merchandise is released to the
consignee's freight forwarder. The buyer is responsible for making arrangements with their
forwarder for insurance, export clearance and handling all other paperwork.
FOB (Free On Board)
One of the most commonly used-and misused-terms, FOB means that the shipper/seller
uses his freight forwarder to move the merchandise to the port or designated point of origin.
Though frequently used to describe inland movement of cargo, FOB specifically refers to
ocean or inland waterway transportation of goods. "Delivery" is accomplished when the
shipper/seller releases the goods to the buyer's forwarder. The buyer's responsibility for
insurance and transportation begins at the same moment.
FCA (Free Carrier)
In this type of transaction, the seller is responsible for arranging transportation, but he is
acting at the risk and the expense of the buyer. Where in FOB the freight forwarder or
carrier is the choice of the buyer, in FCA the seller chooses and works with the freight
forwarder or the carrier. "Delivery" is accomplished at a predetermined port or destination
point and the buyer is responsible for Insurance.
FAS (Free Alongside Ship)*
In these transactions, the buyer bears all the transportation costs and the risk of loss of
goods. FAS requires the shipper/seller to clear goods for export, which is a reversal from
past practices. Companies selling on these terms will ordinarily use their freight forwarder to
clear the goods for export. "Delivery" is accomplished when the goods are turned over to
the Buyers Forwarder for insurance and transportation.
CFR (Cost and Freight)
This term, formerly known as CNF (C&F), defines two distinct and separate responsibilities-
one is dealing with the actual cost of merchandise "C" and the other "F" refers to the freight
charges to a predetermined destination point. It is the shipper/seller's responsibility to get
goods from their door to the port of destination. "Delivery" is accomplished at this time. It is
the buyer's responsibility to cover insurance from the port of origin or port of shipment to
THE buyer's door. Given that the shipper is responsible for transportation, the shipper also
chooses the forwarder.
CIF (Cost, Insurance and Freight)
This arrangement is similar to CFR, but instead of the buyer insuring the goods for the
maritime phase of the voyage, the shipper/seller will insure the merchandise. In this
arrangement, the seller usually chooses the forwarder. "Delivery", as above, is accomplished
at the port of destination.
CPT (Carriage Paid To)
In CPT transactions the shipper/seller has the same obligations found with CIF, with the
addition that the seller has to buy cargo insurance, naming the buyer as the insured while
the goods are in transit.
CIP (Carriage and Insurance Paid To)
This term is primarily used for multimodal transport. Because it relies on the carrier's
insurance, the shipper/seller is only required to purchase minimum insurance coverage.
When this particular agreement is in force, freight forwarders often act in effect, as carriers.
The buyer's insurance is effective when the goods are turned over to the Forwarder.
86

DAF (Delivered At Frontier)
Here the seller's responsibility is to hire a forwarder to take goods to a named frontier,
which usually is a border crossing point, and clear them for export. "Delivery" occurs at this
time. The buyer's responsibility is to arrange with their forwarder for the pick up of the
goods after they are cleared for export, carry them across the border, clear them for
importation and effect delivery. In most cases, the buyer's forwarder handles the task of
accepting the goods at the border across the foreign soil.
DES (Delivered Ex Ship)
In this type of transaction, it is the seller's responsibility to get the goods to the port of
destination or to engage the forwarder to move cargo to the port of destination uncleared.
"Delivery" occurs at this time. Any destination charges that occur after the ship is docked are
the buyer's responsibility.
DEQ (Delivered Ex Quay)*
In this arrangement, the buyer/consignee is responsible for duties and charges and the seller
is responsible for delivering the goods to the quay, wharf or port of destination. In a reversal
of previous practice, the buyer must also arrange for customs clearance.
DDP (Delivered Duty Paid)
DDP terms tend to be used in intermodal or courier-type shipments, whereby the
shipper/seller is responsible for dealing with all the tasks involved in moving goods from the
manufacturing plant to the buyer/consignee's door. It is the shipper/seller's responsibility to
insure the goods and absorb all costs and risks, including the payment of duty and fees.
DDU(Delivered Duty Unpaid)
This arrangement is basically the same as with DDP, except for the fact that the buyer is
responsible for the duty, fees and taxes.

1. Practice Questions
Flexi-Bilt, Inc., of South Carolina, has just purchased a Thai company that manufactures plastic
beams and sockets for childrens construction toys. The purchase price is 120.000.000 Thai baht
(symbol B), with payment due to the selling Thai shareholders in six months. The currency spot rate
is B25.60/$, and the six month forward rate is B26.60/$. Additional data rate as follows:
Six-months Thai baht interest rate: 12 00%p.a
Six-months U.S interest rate: 4.00%p.a
Six-months call option on baht at 26.00 3.0%premium
Six-months put option on baht at 26.00 2.4% premium
Assume that Flexi-Bilt can invest at the given interest rates or borrow at 1% per annum above the
interest rates. Flexi-Bilts weighted average cost of capital is 20%.
a) Compare alternative ways that Flexi-Bilt might deal with its foreign exchange exposure.
b) What do you recommend and why?
2.ELECTRONIX, INC
Electronix, Inc., of Seattle, Washington, sold an Internet protocol system to Kompu-Deutsche of
Germany for DM2, 000,000 with payment due in three months. The following quotes are available:
87

Three-month interest rate (borrowing or investing) 6, 00% per annum
On U.S Dollars.
Three-month interest rate (borrowing or investing) 8.00% per annum
On Deutschemarks:
Spot exchange rate DMI.6000/$
Three-month forward exchange rate: DMI.6120/$
Three-month options from bank of America:
Call option on DM2, 000,000 at exercise price of DM1, 6000/$ and a 1% premium
Put option on DM2, 000,000 at exercise price of DM1.6000/$ and a 3% premium
Electronixs cost of capital is 10.0%, and it wishes to protect the dollar value of this receivable.
a) What are the costs and benefits of each alternative? Which is the best alternative?
b) What is the break-even reinvestment rate when comparing forward and money market
alternatives?

3.VALDIVIA VINEYARDS
Valdivia Vineyards of Chile were recently acquired by Sauvignon Winery of Napa, California. At
present Valdivia is paying 50% p.a.interest on Ps 100 million of five-year, balloon maturity, and peso
debt. It would be possible to refinance this into dollar debt costing only 10% p.a., saving some 40
percentage points over the cost of peso debt.
All of Valdivias wine is exported to the United States, where it is sold for dollars. Valdivia is
allowed by Chilean regulations to use hard currency earned to pay hard currency expenses, including
interest.
The currency exchange rate is Ps32/$, and both Chile and the United States have a rate to drop to
Ps48/$ one year from now, and to continue to deteriorate thereafter at the same rate.
a) As assistant financial manager of Sauvignon Winery in charge of the Latin American
Beverage Division, should you refinance Valdivias Chilean peso debt into dollars?
b) Would your answer be different if all of Valdivias sales were within Chile? (Explain and
show your calculation.)
4.GAMBOAS TAX AVERAGING
Gamboa, Incorporated, is a relatively new U.S-Based retailer of specialty fruits and vegetables. The
firm is vertically integrated with fruit and vegetable-sourcing subsidiaries in Central America, and
distribution outlets throughout the southeastern and northeastern region of the United States.
Gamboas two Central American subsidiaries are in Belize and Costa Rica.
88

Maria Gamboa, the daughter of the firms founder, is being groomed to take over the firms financial
management in the near future. Like many firms of Gamboas size, it has not possessed a very high
degree of sophistication in financial management, simply out of time and cost considerations. Maria,
however, has recently finished her MBA and is now attempting to put some specialized knowledge
of U.S taxation practices to work to save Gamboa money. Her first concern is tax averaging for
foreign tax liabilities arising from the two Central American subsidiaries.
Costa Rican operations are slightly more profitable than Belize, which is particularly good since Costa
Rica is a relatively low-tax country. Costa Rican corporate taxes are a flat 30%, and there are no
withholding taxes imposed on dividends paid by foreign firms with operations there. Belize has a
higher corporate income tax rate of 40%, and imposes a 10% withholding tax on all dividends
distributed to foreign investors. The current U.S. corporate income tax rate is 35%.
Belize Costa Rica
Earnings before taxes $1, 000,000 $1, 500,000
Corporate income tax rate 40% 30%
Dividend withholding tax rate 10% 0%

a. If Maria Gamboa assumes a 50% payout rate from each subsidiary, what are the additional
taxes due on foreign-sourced income from Belize and Costa Rica individually? How much in
additional U.S. taxes would be due if Maria averaged the tax credits/liabilities of the two
units?
b. Keeping the payout rate from the Belize subsidiary at 50%, how should Maria change the
payout rate of the Costa Rican subsidiary in order to most efficiently manage her total
foreign tax bill?
c. What is the minimum effective tax rate which Maria can achieve on her foreign sourced
income? `
5.PRETORIA PRODUCTIONS, LTD
Hollywood Video, Inc., of Los Angeles, California, wants to loan US$6, 000,000 to its new South
African affiliate, Pretoria Productions, Ltd. Pretoria Productions was formed after the election victory
of Nelson Mandela to produce and distribute Hollywood movies in video form throughout South
Africa. Hollywood Video owns a wholly owned finance subsidiary in Malta, which is used to redirect
funds between affiliates in the eastern hemisphere.
Corporate income taxes are 34% in the United States and 48% in South Africa. No taxes are levied in
Malta. Hollywood Video may either (1) have its Maltese finance subsidiary loans $6 million directly
to Pretoria Productions, or (2) have the Maltese subsidiary deposit $6 million in National
Westminster Bank (NatWest), London, at 11.5%. NatWest would then loan the same sum at 12% to
Pretoria Productions. NatWest would charge only 0.5% to act as a financial intermediary because
none of its own funds are at risk, as Maltas deposit provides 100% collateral. Which option do you
advocate and why?
89


Past Final Examination Papers 1

SECTION A (ANSWER ALL QUESTIONS FROM THIS SECTION)

QUESTION ONE
1.(a) Explain the fundamental technique for forecasting exchange rates (5 marks)
1.(b) Explain how the theory of comparative advantage relates to the need for international
business. (5 marks)
1.(c) How is the product life cycle related to the growth of MNCs? (5 Marks)
1.(d) How would a weakening Zimbabwean dollar affect its balance of payment? (10 marks )
QUESTION TWO
2. (a) You are given the following information:
Spot rate USD = 26.50MT
180-day forward rate of USD = 25.60MT
180-day American Interest rate = 15%
180-day Mozambiquean interest rate = 12%
Based on this information, is covered interest arbitrage by a Mozambiquean investor feasible?
Explain. Assume the investor starts with 1 000 000Meticals. (8 marks)
2(b). Assume that the Central Bank of Mozambique believes that the Metical should be weakened
against the United States dollar. Discuss how it would use indirect intervention strategy to
weaken the Meticals value with respect to the dollar. If the future inflation rate in Mozambique is
expected to be high, why would the Central Bank Of Mozambique attempt to weaken the Metical?
(17 marks)
SECTION 2 (ANSWER ANY TWO QUESTIONS FROM THIS SECTION)
QUESTION THREE

What factors affect a firms degree of transaction exposure in a particular currency? For each
factor, explain the desirable characteristics that would reduce exposure. (25 marks)
QUESTION FOUR
Describe some potential benefits to the MNC as a result of direct foreign investment (DFI). To
what extent do they apply to FDI investment in Mozambique? (25 marks)
90

QUESTION FIVE
Identify common political and economic factors for an MNC to consider when assessing country
risk. Briefly explain how each factor can affect the risk to the MNC. (25 Marks)
QUESTION SIX
Discuss the following terms:

6.(a) Interest Parity Theory
(b) Purchasing Power Parity Theory
(c)International Fisher Effect
(d) Interest Covered Arbitrage
(e) Forward Rate agreement
SECTION A (ANSWER ALL QUESTIONS FROM THIS SECTION)
QUESTION ONE

1.(a) Explain the motives for forecasting exchange rates by MNCs. (5 marks)
1.(b) Assume an MNC hires you as a consultant to assess its degree of economic exposure
to exchange rate fluctuations. How would you handle this task? Be brief and specific. (7)
marks)
1.(c) Assume the following information for BIM, a local bank:
Value of Mozambiquean Metical in Rands = R0.2857
Value of Swaziland Emalangeni in Rands = R0.O952
Value of Mozambiquean Metical in Swaziland Emalangeni = R3.300

Given this information, is triangular arbitrage possible? If so, explain the steps that would
reflect arbitrage , and compute the profit from this strategy if you had 100 000 MT to
use.(8 marks)
(d) Under what conditions would an MNC subsidiary consider use of a leading strategy
to reduce transaction exposure? (5 marks)
QUESTION TWO
2.(a) A local company, Terminus Hotel, has contracted to purchase 1000 air conditioners at
US$200 each. It has been granted 6 months to settle the account. The company can borrow
at 7% above base rate in either market and invest at 6% below base rate in both markets as
well. The current market rates are 13% in the US market and 22% in Mozambique.

The exchange rates are as follows:

MT per USD
Spot Rates 26.65 28.70
I month Forward 29.20 - 30.24
91

6 Months Forward 31.24 -33.24

Illustrate possible policies that Terminus Hotel might follow regarding this transaction
and provide a recommendation for which policy Terminus Hotel must follow. (20 marks)

2.(b). Define the terms transaction exposure , economic exposure and translation exposure (5
marks)

SECTION TWO (CHOOSE ANY TWO QUESTIONS FROM THIS SECTION)
QUESTION THREE
Why would the Government of Zimbabwe provide MNCs with incentives to undertake DFI in its
country? (25 marks)
QUESTION FOUR
4(a) How can the Central Bank of Mozambique use indirect intervention to change the value of the
currency? (10 marks)
4(b) Should the Government of Mozambique allow its currency to float freely? What would be the
advantages of letting their currencies float freely? What would be the disadvantages for this
approach? (15 marks)
QUESTION FIVE
5. (a) Explain how diversification can be used by a company to reduce transaction exposure. (15
marks)
5. (b) When is it optimal for an MNC to rely on centralised currency hedge mechanisms. (10 marks)
QUESTION SIX
Discuss reasons advanced by MNCs for foreign investment. To what extent do they apply to FDI
investment in Mozambique? (25 marks)
QUESTION SEVEN
Montclair Company, a United States of America Co., plans to use a money market hedge to hedge
its payment of $3 000 000 for Australian goods in one year. The U.S. interest rate is 7%, while the
Australian interest rate is 12%. The spot exchange rate of the Australian dollar is $0.85, while the
one year forward rate is $0.81.
A) Determine the amount of US$s needed in one year if a money market hedge is used.
B) Determine the amount of US $s needed in one year if a
C)
D)
E) forward market hedge is used?
Reference List
92

Buckley, A. (2004) Multinational Finance , 5
th
edition, FT Prentice Hall
Eiteman , D.K, Stonehill, A.I. and Moffet, M.H. (2007) Multinational Business Finance , 11
th
edition,
Addison-Wesley
Eun, C,S. and Rennick, B.G. (2006) International Financial Managaement, 4
th
edition, McGraw-Hill.
Madura, J. (2006) International Corporate, 8
th
edition Fiance on, Thomson
Pilbeam, K. (2006) International Finance , 3
rd
edition, Palgrave.
Shapiro, A.C. (2006) Multinational Financial Management, 8
th
edition, John Wiley & Sons